Conflicts of Interest Associated With the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers, 53960-54024 [2023-16377]

Download as PDF 53960 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 240 and 275 [Release Nos. 34–97990; IA–6353; File No. S7–12–23] RIN 3235–AN00; 3235–AN14 Conflicts of Interest Associated With the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers Securities and Exchange Commission. ACTION: Proposed rule. AGENCY: The Securities and Exchange Commission (‘‘Commission’’ or ‘‘SEC’’) is proposing new rules (‘‘proposed conflicts rules’’) under the Securities Exchange Act of 1934 (‘‘Exchange Act’’) and the Investment Advisers Act of 1940 (‘‘Advisers Act’’) to eliminate, or neutralize the effect of, certain conflicts of interest associated with brokerdealers’ 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 Commission is also proposing amendments to rules under the Exchange Act and Advisers Act that would require firms to make and maintain certain records in accordance with the proposed conflicts rules. DATES: Comments should be received on or before October 10, 2023. ADDRESSES: Comments may be submitted by any of the following methods: SUMMARY: Electronic Comments • Use the Commission’s internet comment form (https://www.sec.gov/ rules/proposed.shtml); or • Send an email to rule-comments@ sec.gov. Please include File Number S7– 12–23 on the subject line. lotter on DSK11XQN23PROD with PROPOSALS2 Paper Comments • Send paper comments to Vanessa A. Countryman, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–1090. All submissions should refer to File Number S7–12–23. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method of submission. The Commission will post all comments on the Commission’s website (https:// www.sec.gov/rules/proposed.shtml). Comments are also available for website viewing and printing in the VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 Commission’s Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. Operating conditions may limit access to the Commission’s Public Reference Room. Do not include personal identifiable information in submissions; you should submit only information that you wish to make available publicly. We may redact in part or withhold entirely from publication submitted material that is obscene or subject to copyright protection. Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the Commission’s website. To ensure direct electronic receipt of such notifications, sign up through the ‘‘Stay Connected’’ option at www.sec.gov to receive notifications by email. FOR FURTHER INFORMATION CONTACT: Blair B. Burnett, Senior Counsel, Investment Company Regulation Office, Michael Schrader, Senior Counsel, Chief Counsel’s Office, Sirimal R. Mukerjee, Senior Special Counsel, and Melissa Roverts Harke, Assistant Director, Investment Adviser Regulation Office, Division of Investment Management, at (202) 551–6787 or IArules@sec.gov, and Kyra Grundeman and James Wintering, Special Counsels, Anand Das, Senior Special Counsel, Kelly Shoop, Branch Chief, Devin Ryan, Assistant Director, John Fahey, Deputy Chief Counsel, and Emily Westerberg Russell, Chief Counsel, Office of Chief Counsel, Division of Trading and Markets, at (202) 551–5550 or tradingandmarkets@ sec.gov, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–8549. SUPPLEMENTARY INFORMATION: The Commission is proposing for public comment: 17 CFR 240.15l–2 under the Exchange Act 1 (‘‘proposed rule 240.151–2’’) and 17 CFR 275.211(h)(2)– 4 under the Advisers Act 2 (‘‘proposed rule 275.211(h)(2)–4’’ and, together with proposed rule 240.15l–2, ‘‘proposed conflicts rules’’); and amendments to 17 CFR 240.17a–3 and 17 CFR 240.17a–4 (‘‘rules 17a–3 and 17a–4’’) under the Exchange Act and 17 CFR 275.204–2 1 Unless otherwise noted, when we refer to the Exchange Act, we are referring to 15 U.S.C. 78, and when we refer to rules under the Exchange Act, we are referring to title 17, part 240 of the Code of Federal Regulations [17 CFR 240]. 2 Unless otherwise noted, when we refer to the Advisers Act, we are referring to 15 U.S.C. 80b, and when we refer to rules under the Advisers Act, we are referring to title 17, part 275 of the Code of Federal Regulations [17 CFR 275]. PO 00000 Frm 00002 Fmt 4701 Sfmt 4702 under the Advisers Act (‘‘rule 204–2’’ and, together with the proposed amendments to rules 17a–3 and 17a–4, ‘‘proposed recordkeeping amendments’’). Table of Contents I. Introduction A. Overview B. Background 1. Evolution in the Investment Industry and its Technology Use 2. Current PDA-Like Technology Use and Expected Growth 3. Commission Protection of Investors as Technology Has Evolved 4. Use of Predictive Data Technologies in Investor Interactions 5. Request for Information and Comment C. Overview of the Proposal II. Discussion A. Proposed Conflicts Rules 1. Scope 2. Identification, Determination, and Elimination, or Neutralization of the Effect of, a Conflict of Interest 3. Policies and Procedures Requirement B. Proposed Recordkeeping Amendments III. Economic Analysis A. Introduction B. Broad Economic Considerations C. Economic Baseline 1. Affected Parties 2. Technology and Market Practices 3. Regulatory Baseline D. Benefits and Costs 1. Benefits 2. Costs E. Effects on Efficiency, Competition, and Capital Formation 1. Efficiency 2. Competition 3. Capital Formation F. Reasonable Alternatives 1. Expressly Permit, or Require, the Use of Independent Third-Party Analyses 2. Require That Senior Firm Personnel and/or Specific Technology SubjectMatter Experts Participate in the Process of Adopting and Implementing These Policies and Procedures 3. Provide an Exclusion for Technologies That Consider Large Datasets Where Firms Have No Reason To Believe the Dataset Favors the Interests of the Firm From the Identification, Evaluation, and Testing Requirements 4. Apply the Requirements of the Proposed Conflicts Rule and Proposed Recordkeeping Amendments Only to Broker-Dealer Use of Covered Technologies That Have NonRecommendation Investor Interaction 5. Require That Firms Test Covered Technologies on an Annual Basis, or at a Specific Minimum Frequency 6. Require That Firms Provide a Prescribed and Standardized Disclosure G. Request for Comment IV. Paperwork Reduction Act A. Introduction B. Proposed Conflicts Rules and Proposed Recordkeeping Amendments C. Request for Comment V. Initial Regulatory Flexibility Analysis E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules A. Reason for and Objectives of the Proposed Action 1. Proposed Rules 151–2 and 211(h)(2)–4 2. Proposed Amendments to Rules 17a–3 and 17a–4 and Rule 204–2 B. Legal Basis C. Small Entities Subject to the Rules and Rule Amendments 1. Small Advisers Subject to Proposed Rule 211(h)(2)–4 and Proposed Amendments to Recordkeeping Rule D. Small Broker-Dealers Subject to Proposed Conflicts Rule and Amendments to Recordkeeping Rules E. Projected Reporting, Recordkeeping, and Other Compliance Requirements 1. Proposed Conflicts Rules 2. Proposed Amendments to Rule 204–2 3. Proposed Amendments to Rules 17a–3 and 17a–4 F. Duplicative, Overlapping, or Conflicting Federal Rules 1. Proposed Rule 211(h)(2)–4 and Proposed Amendments to Rule 204–2 2. Proposed Rule 15l–2 and Proposed Amendments to Rules 17a–3 and 17a–4 G. Significant Alternatives H. Solicitation of Comments VI. Consideration of Impact on the Economy Statutory Authority Text of Proposed Rules and Form Amendments lotter on DSK11XQN23PROD with PROPOSALS2 I. Introduction The adoption and use of newer technologies, such as predictive data analytics (‘‘PDA’’), by broker-dealers and investment advisers (together, ‘‘firms’’) have accelerated.3 In some instances, firms’ use of PDA and similar 3 See Deloitte, Artificial intelligence: The next frontier for investment management firms (Feb. 5, 2019), https://www.deloitte.com/global/en/ Industries/financial-services/perspectives/ai-nextfrontier-in-investment-management.html (‘‘AI is providing new opportunities which extend far beyond cost reduction and efficient operations. Many investment management firms have taken note and are actively testing the waters, applying cognitive technologies and AI to various business functions across the industry value chain.’’); Blake Schmidt and Amanda Albright, AI Is Coming for Wealth Management. Here’s What That Means, Bloomberg Markets (Apr. 21, 2023), https:// www.bloomberg.com/news/articles/2023-04-21/ vanguard-fidelity-experts-explain-how-ai-ischanging-wealth-management (discussing experts views on AI impact on the wealth management industry). As discussed more below, in addition to PDA, firms have adopted and used artificial intelligence (‘‘AI’’), including machine learning, deep learning, neural networks, natural language processing (‘‘NLP’’), or large language models (including generative pre-trained transformers or ‘‘GPT’’), as well as other technologies that make use of historical or real-time data, lookup tables, or correlation matrices (collectively, ‘‘PDA-like technologies’’). See, e.g., Q. Zhu and J. Luo, Generative Pre-Trained Transformer for Design Concept Generation: An Exploration, Proceedings of the Design Society, Design Vol 2 (May 2022), https://www.cambridge.org/core/journals/ proceedings-of-the-design-society/article/ generative-pretrained-transformer-for-designconcept-generation-an-exploration/ 41894D82DCBC0610B5B6E68967B7047F (‘‘GPT are language models pre-trained on vast quantities of textual data and can perform a wide range of language-related tasks.’’) (citations omitted). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 technologies may be subject to statutory or regulatory investor protections, but in other cases, it may not. Firms’ use of PDA-like technologies can bring benefits in market access, efficiency, and returns. To the extent that firms are using PDA-like technologies to optimize for their own interests in a manner (intentionally or unintentionally) that places these interests ahead of investor interests, however, investors can suffer harm. Further, due to the scalability of these technologies and the potential for firms to reach a broad audience at a rapid speed, as discussed below, any resulting conflicts of interest could cause harm to investors in a more pronounced fashion and on a broader scale than previously possible.4 We believe the current regulatory framework should be updated to help ensure that firms are appropriately addressing conflicts of interests associated with the use of PDA-like technologies. As a result, we are proposing specific protections to complement those already required under existing regulatory frameworks 5 to better protect investors from harms arising from these conflicts. A. Overview Broker-dealers may have a range of conflicts of interest with their retail investors.6 Likewise, investment advisers may have conflicts of interest with respect to advisory clients and investors in their pooled investment vehicle clients.7 Some of these conflicts of interest are inherent to the relationship between these firms and investors. For example, an investment adviser that is paid a percentage fee based on assets under management has an incentive to encourage a client to move assets into his or her advisory account, which could conflict with investors’ interest, for example, to retain assets in a 401(k) plan or other retirement account. Similarly, a brokerdealer that receives transaction-based (e.g., commission) compensation has an 4 See infra section I.C. infra section III.C.3. 6 While the proposed conflicts rules do not use or define the term ‘‘retail investors,’’ we use that term in this release to mean ‘‘a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes,’’ which is consistent with the definition of ‘‘retail investor’’ in Form CRS and would include both current and prospective retail customers. See Form CRS, Sec. 11.E. Separately, we note that, for broker-dealers, the proposed conflicts rule defines ‘‘investor’’ consistent with the definition of ‘‘retail investor’’ in Form CRS. 7 Proposed rule 275.211(h)(2)–4 would apply to clients and prospective clients of advisers as well as investors and prospective investors in pooled investment vehicles advised by those advisers. 5 See PO 00000 Frm 00003 Fmt 4701 Sfmt 4702 53961 incentive to maximize the frequency of transactions, which could increase costs to the investor or expose them to other risks associated with excess trading. Many broker-dealers and investment advisers also have conflicts of interest associated with other common business practices. For example, some investment product sponsors offer revenue sharing payments, creating an incentive for broker-dealers and investment advisers that accept such payments to favor those investments. Similarly, firms that offer proprietary products have an incentive to favor those products over other nonproprietary alternatives. Dual registrant and affiliated firms that offer both brokerage and advisory accounts have an incentive to steer investors toward the account type that is most profitable for the firm, regardless of whether it is in the best interest of the investor. Unless adequately addressed, these conflicts of interest can cause brokerdealers and investment advisers to place their interests ahead of investors’ interests. Broker-dealers and investment advisers operate within regulatory frameworks that in many cases require them to, as applicable, disclose, mitigate, or eliminate conflicts.8 These regulatory frameworks play a fundamental role in protecting retail investors of broker-dealers, clients of investment advisers, and investors in pooled investment vehicle clients of investment advisers (together, ‘‘investors’’) from the negative effects of firms placing their own interests ahead of investors’ interests. As the markets grow and evolve, however, and specifically, as firms adopt and utilize newer technologies to interact with investors, we are evaluating our regulations’ effectiveness in protecting investors from the potentially harmful impact of conflicts of interest. Recently, firms’ adoption and use of PDA-like technologies 9 have 8 See https://www.sec.gov/rules/final/2019/3486031.pdf, Exchange Act Release No. 86031 (June 5, 2019) [84 FR 33318 (July 12, 2019)] (‘‘Reg BI Adopting Release’’); Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Advisers Act Release No. 5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)], at section II.C. (‘‘Fiduciary Interpretation’’) (describing an adviser’s fiduciary duties to its clients). Additionally, rule 206(4)–8 under the Advisers Act prohibits certain statements, omissions, and other acts, practices, or courses of business as fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in a pooled investment vehicle. 9 Artificial intelligence is generally used to mean the capability of a machine to imitate intelligent human behavior and machine learning is a subfield of artificial intelligence that gives computers the E:\FR\FM\09AUP2.SGM Continued 09AUP2 53962 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 accelerated.10 While this adoption and use can bring potential benefits for firms and investors (e.g., with respect to efficiency of operations, which can generate cost savings for investors, or enhancing the efficiency of identifying investment opportunities that match an investor’s preferences, profile, and risk tolerances), they also raise the potential for conflicts of interest associated with the use of these technologies to cause harm to investors more broadly than before.11 While the presence of conflicts of interest between firms and investors is not new, firms’ increasing use of these PDA-like technologies in investor interactions may expose investors to unique risks. This includes the risk of conflicts remaining unidentified and therefore unaddressed or identified and unaddressed. The effects of such unaddressed conflicts may be pernicious, particularly as this technology can rapidly transmit or scale conflicted actions across a firm’s investor base.12 For example, conflicts ability to learn without explicitly being programmed. See generally Sara Brown, Machine Learning, Explained, MIT Sloan School of Management (Apr. 21, 2021), https:// mitsloan.mit.edu/ideas-made-to-matter/machinelearning-explained. Predictive data analytics draws inferences from large data sets, relying on hypothesis-free data mining and inductive reasoning to uncover patterns to make predictions about future outcomes, and may use natural language processing, signal processing, topic modeling, pattern recognition, machine learning, deep learning, neural networks, and other advanced statistical methods. See Nathan Cortez, Predictive Analytics Law and Policy: Mapping the Terrain: Challenging Issues in Specific Private Sector Contexts, Substantiating Big Data in Health Care, 14 ISJLP 61, 65 (Fall 2017). See generally Financial Industry Regulatory Authority, Inc. (‘‘FINRA’’), Artificial Intelligence (AI) in the Securities Industry 5 (June 2020) (‘‘FINRA AI Report’’), https:// www.finra.org/sites/default/files/2020-06/ai-report061020.pdf; Financial Stability Board, Artificial Intelligence and Machine Learning in Financial Services: Market Developments and Financial Stability Implications (Nov. 1, 2017) (‘‘FSB AI Report’’), https://www.fsb.org/wp-content/uploads/ P011117.pdf; see also Department of the Treasury, et al., Request for Information and Comment on Financial Institutions’ Use of Artificial Intelligence, Including Machine Learning (Feb. 2021) [86 FR 16837, 16839–40 (Mar. 31, 2021)] (‘‘Treasury RFI’’). 10 See infra section I.B. 11 See, e.g., For AI in Asset Management, Tomorrow is Here, Markets Media (Mar. 28, 2023), https://www.marketsmedia.com/for-ai-in-assetmanagement-tomorrow-is-here/ (citing possible benefits for investment managers in generating alpha, improving efficiency, enhancing product and content distribution, and enhancing risk management and customer experience); Christine Schmid, AI in Wealth: from Science Fiction to Science Fact, FinExtra (June 8, 2023), https:// www.finextra.com/blogposting/24323/ai-in-wealthfrom-science-fiction-to-science-fact (citing potential benefits in personalized portfolio creation, enhanced investor engagement, democratized personalized investing, and reduced information overload). 12 See, e.g., Sophia Duffy and Steve Parrish, You Say Fiduciary, I Say Binary: A Review and VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 of interest can arise from the data the technology uses (including any investor data) and the inferences the technology makes (including in analyzing that data, other data, securities, or other assets). These issues may render a firm’s identification of such conflicts for purposes of the firm’s compliance with applicable Federal securities laws more challenging without specific efforts both to fully understand the PDA-like technology it is using 13 and to oversee conflicts that are created by or transmitted through its use of such technology.14 Moreover, PDA-like technologies may have the capacity to process data, scale outcomes from analysis of data, and evolve at rapid rates.15 While valuable in many circumstances, these technologies could rapidly and exponentially scale the transmission of any conflicts of interest associated with such technologies to investors.16 For Recommendation of Robo-Advisors and the Fiduciary and Best Interest Standards, 17 Hastings Bus. L.J. 3, at 26 (2021) (stating that the impact of firm conflicts of robo-advisors ‘‘are arguably more detrimental than personal conflicts between an advisor and client because the number of clients impacted by the firm conflict is potentially exponentially higher.’’) (‘‘Robo-Advisors and the Fiduciary and Best Interest Standards’’). 13 See, e.g., infra section II.A.2.b and II.A.3 (discussing the testing and policies and procedures requirements, respectively, of the proposed conflicts rules, which if implemented in accordance with the proposal, would necessitate firms’ developing an understanding of the PDA-like technologies they use). 14 See, e.g., Sohnke M. Bartram, Jurgen Branke & Mehrshad Motahari, Artificial Intelligence in Asset Management (2020) (‘‘AI in Asset Management’’) (‘‘Understanding and explaining the inferences made by most AI models is difficult, if not impossible. As the complexity of the task or the algorithm grows, opacity can render human supervision ineffective, thereby becoming an even more significant problem.’’). 15 See, e.g., Eray Elicik, Artificial Intelligence vs. Human Intelligence: Can a game-changing technology play the game? (Apr. 20, 2022), https:// dataconomy.com/2022/04/is-artificial-intelligencebetter-than-human-intelligence/ (‘‘Compared to the human brain, machine learning (ML) can process more data and do so at a faster rate.’’); David Nield, Google Engineers ‘Mutate’ AI to Make It Evolve Systems Faster Than We Can Code Them (Apr. 17, 2020), https://www.sciencealert.com/codersmutate-ai-systems-to-make-them-evolve-faster-thanwe-can-program-them (‘‘[R]esearchers have tweaked [a machine learning system] to incorporate concepts of Darwinian evolution and shown it can build AI programs that continue to improve upon themselves faster than they would if humans were doing the coding.’’). 16 See Robo-Advisors and the Fiduciary and Best Interest Standards, supra note 12, at 26. See also FINRA AI Report, supra note 9 (discussing exploration of the use of AI tools by market participants and noting, among other things, that firms should ensure sound governance and supervision, including effective means of overseeing suitability of recommendations, conflicts of interest, customer risk profiles and portfolio rebalancing) (internal quotations and citation omitted); Y. Minsky, Communications of the ACM, OCaml for the Masses (Sept. 27, 2011), https:// PO 00000 Frm 00004 Fmt 4701 Sfmt 4702 example, a firm may use PDA-like technologies to automatically develop advice and recommendations that are then transmitted to investors through the firm’s chatbot, push notifications on its mobile trading application (‘‘app’’), and robo-advisory platform. If the advice or recommendation transmitted is tainted by a conflict of interest because the algorithm drifted 17 to advising or recommending investments more profitable to the firm or because the dataset underlying the algorithm was biased toward investments more profitable to the firm, the transmission of this conflicted advice and recommendations could spread rapidly to many investors. Unless adequately addressed, the use of these PDA-like technologies may create or transmit conflicts of interest that place a firm’s interests ahead of investors’ interests. This may arise not only when a firm is providing investment advice or recommendations, but also in the firm’s sales practices and investor interactions more generally, such as design elements, features, or communications that nudge or prompt more immediate and less informed action by the investor.18 In light of these developments and risks, and for the reasons we describe further below, we are proposing that a firm’s use of certain PDA-like technologies in an investor interaction that places the firm’s interests ahead of the investors’ interests involves a conflict of interest that must be eliminated or its effects neutralized in accordance with the proposed conflicts rules. B. Background 1. Evolution in the Investment Industry and Its Technology Use Over the last several decades, firms’ use of technology to interact with investors and provide products and services has evolved significantly, and with it, the nature and extent of the conflicts of interest this use can create. When Congress first enacted the dl.acm.org/doi/pdf/10.1145/2018396.2018413 (explaining that ‘‘technology carries risk. There is no faster way for a trading firm to destroy itself than to deploy a piece of trading software that makes a bad decision over and over in a tight loop’’ and that the author’s employer seeks to control these risks by ‘‘put[ting] a very strong focus on building software that was easily understood—software that was readable.’’). 17 See infra note 157 and accompanying text. 18 See, e.g., CFA Institute, Ethics and Artificial Intelligence in Investment Management: A Framework for Professionals (2022) (stating that professionals should ensure they understand the sources of any potential conflicts generated by the use of algorithms and work with developers to ensure that such systems do not inappropriately incorporate fee considerations in the algorithm generating the investment advice). E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 Exchange Act and the Advisers Act, firms were increasingly deploying what were then considered advanced technologies, such as punch cards and telex machines. As technology improved, firms began adopting other technologies, such as computers, email, spreadsheets, and the internet. The Commission has previously observed that these and other technologies have helped to promote transparency, liquidity, and efficiency in our capital markets.19 If responsibly implemented and overseen by firms, new technologies can aid firms’ interactions with investors, and bring greater access and product choice, potentially at a lower cost, without compromising investor protection, capital formation, and fair, orderly, and efficient markets. Where once investors placed trades with their broker in-person, they eventually began to place orders over the phone, and then through a website. Now investors can instantaneously place a trade directly through an app on a smart phone and, instead of a recommendation delivered by a human, they may receive push notifications potentially designed to affect trading behavior. These technological interactions can be designed to respond to human behavior, for example, sending increased notifications for certain investment products depending on where the person scrolling through investment products pauses on her smartphone. As technology continues to evolve, we believe that firms are likely to increase their reliance on behavioral science frameworks in influencing investor behavior.20 Investors that 19 See Interpretation on Use of Electronic Media, Investment Company Act Release No. 24426 (Apr. 28, 2000) [65 FR 25843 (May 4, 2000)], at section I; see also Investment Adviser Marketing, Investment Advisers Act No. 5653 (Dec. 22, 2020) [86 FR 13024 (Mar. 5, 2021)], at section I (‘‘Investment Adviser Marketing Release’’) (noting that the rules are ‘‘designed to accommodate the continual evolution and interplay of technology and advice’’). 20 See, e.g., Robert W. Cook, President and CEO of FINRA, Statement Before the Financial Services Committee U.S. House of Representatives (May 6, 2021), https://www.finra.org/media-center/ speeches-testimony/statement-financial-servicescommittee-us-house-representatives (addressing the ‘‘recent trends of retail trading platforms is the use of ‘game-like’ and other features that may encourage investor behaviors’’ and ‘‘the growing prevalence of these features’’); Margaret Franklin, Investment Gamification: Not All Cons, Some Important Pros, Kiplinger (Feb. 20, 2023), https:// www.kiplinger.com/investing/investmentgamification-pros-and-cons (discussing the use of behavioral techniques and the rising influence of social media, and stating that the gamification ‘‘style of trading, ushered in largely by the next generation of investors, is likely here to stay.’’). See also James Tierney, Investment Games, 72 Duke L.J. 353, 355 (Nov. 2022) (describing the growth of retail investing and discussing gamification, including how ‘‘mobile app developers have innovated in VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 previously met in person with their advisers are now able to access computer-generated advice that is delivered rapidly in an app to many investors by, for example, a roboadviser. Rather than advertising in local newspapers, making cold calls, or relying on referrals, firms are now digitally targeting investors.21 In recent years, we have observed a rapid expansion in firms’ reliance on technology and technology-based products and services.22 The use of technology is now central to how firms provide their products and services to investors.23 Some firms and investors in user-interface design to compete with incumbent brokers [by including features such as] intuitive and appealing design, as well as digital engagement practices that encourage interaction with the app and that shape the information users consider in investing,’’); Jill E. Fisch, GameStop and the Reemergence of the Retail Investor, 102 B.U. L. Rev. 1799, 1802 (Oct. 2022) (discussing gamification and the ‘‘evidence that retail investment and engagement will both continue and evolve.’’); Ernst & Young, Social investing: behavioral insights for the modern wealth manager (Apr. 2021), https:// www.ey.com/en_us/wealth-asset-management/ social-investing-behavioral-insights-for-the-modernwealth-manager (‘‘As firms continue to develop social investing operating models, they can use behavioral science frameworks to better understand how their client segments are influenced by digital design and choice architecture[.]’’). 21 See, e.g., Disclosure Innovations in Advertising and Other Communications with the Public, FINRA Regulatory Notice 19–31 (Sept. 19, 2019), https:// www.finra.org/rules-guidance/notices/19-31; see also Leslie K. John, Tami Kim, and Kate Barasz, Ads that Don’t Overstep, Harvard Bus. Rev. (Jan.– Feb. 2018), https://hbr.org/2018/01/ads-that-dontoverstep. 22 See generally Marc Andreessen, Why Software Is Eating the World, Wall St. J. (Aug. 20, 2011), https://www.wsj.com/articles/SB10001424053111 903480904576512250915629460 (discussing, among other things, the transformation of the financial services industry by software over the last 30 years) (‘‘Why Software is Eating the World’’); Robo-Advisors and the Fiduciary and Best Interest Standards, supra note 12, at 4 (stating that ‘‘[o]ver the past decade, robo-advisors, or automated systems for providing financial advice and services, are becoming more and more popular’’ and discussing estimated growth); Nicole G. Iannarone, Fintech’s Promises and Perils Computer as Confidant: Digital Investment Advice and the Fiduciary Standard, 93 Chi.-Kent L. Rev. 141, 141 (2018) (‘‘Automated investment advisers permeate the investment industry. Digital investment advisers are the fastest growing segment of financial technology (FinTech) and are disrupting traditional investment advisory delivery models.’’) (citations omitted). 23 See, e.g., Investment Adviser Marketing Release, supra note 19, at section I (‘‘The concerns that motivated the Commission to adopt the advertising and solicitation rules [in 1961 and 1979, respectively] still exist today, but investment adviser marketing has evolved with advances in technology. In the decades since the adoption of both the advertising and solicitation rules, the use of the internet, mobile applications, and social media has become an integral part of business communications. Consumers today often rely on these forms of communication to obtain information, including reviews and referrals, when considering buying goods and services. Advisers and third parties also rely on these same types of PO 00000 Frm 00005 Fmt 4701 Sfmt 4702 53963 financial markets now use new technologies such as AI, machine learning, NLP, and chatbot technologies to make investment decisions and communicate between firms and investors.24 In addition, existing technologies for data-analytics and data collection continue to improve and find new applications.25 2. Current PDA-Like Technology Use and Expected Growth Financial market participants currently use AI and machine learning technologies in a variety of ways. For example, algorithmic trading is a widely used application of machine learning in finance, where machine-learning models analyze large datasets and identify patterns and signals to optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes.26 Moreover, the advent and growth of services available on certain digital platforms, such as those offered by online brokerages and robo-advisers, have multiplied the opportunities for retail investors, in particular, to invest and trade in securities, and in small amounts through fractional shares.27 outlets to attract and refer potential customers.’’); FINRA Investor Education Foundation, Investors in the United States: The Changing Landscape (Dec. 2022) https://www.finrafoundation.org/sites/ finrafoundation/files/NFCS-Investor-ReportChanging-Landscape.pdf (discussing, among others, website and mobile app use for placing trades and use of social media sites for obtaining investment information). 24 Michael Kearns & Yuriy Nevmyvaka Machine Learning for Market Microstructure and High Frequency Trading, High Frequency Trading—New Realities for Traders, Markets and Regulators (David Easley, Marcos Lopez de Prado & Maureen O’Hara editors, Risk Books, 2013); see also Christian Thier & Daniel dos Santos Monteiro, How Much Artificial Intelligence Do Robo-Advisors Really Use? (Aug. 31, 2022), https://ssrn.com/abstract=4218181; Imani Moise, Bond Investing Gets the Robo-Adviser Treatment, The Wall Street Journal (June 7, 2023), https://www.wsj.com/articles/buying-bonds-is-hardheres-a-way-to-let-a-robot-do-it-70a4587b. 25 Natasha Lekh & Petr Pa ´ tek, What’s the Future of Web Scraping in 2023?, APIFY Blog (Jan. 20, 2023), https://blog.apify.com/future-of-webscraping-in-2023/; Jon Martindale, Best Apps to Use GPT–4, Digitaltrends (May 4, 2023), https:// www.digitaltrends.com/computing/best-apps-touse-gpt-4/. 26 See generally Alessio Azzutti, Wolf-Goerge Ringe, H. Siegfried Stiehl, Machine Learning, Market Manipulation, and Collusion on Capital Markets: Why the ‘‘Black Box’’ Matters, 43 U. Pa. J. Int’l L. 1 (2021), https:// scholarship.law.upenn.edu/cgi/ viewcontent.cgi?article=2035&context=jil (‘‘Machine Learning and Market Manipulation’’) (discussing current uses of algorithmic trading and exploring the risks to market integrity in connection with the evolving uses of artificial intelligence in algorithmic trading). 27 See, e.g., Nolan Schloneger, A Case for Regulating Gamified Investing, 56 Ind. L. Rev. 175 (2022) (‘‘Th[e] rise [of investing applications] is largely attributed to zero commission and E:\FR\FM\09AUP2.SGM Continued 09AUP2 53964 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 This increased accessibility has been one of the key factors associated with the increase of retail investor participation in U.S. securities markets in recent years.28 Firms have also expanded their use of technology to include ‘‘digital engagement practices’’ or ‘‘DEPs,’’ such as behavioral prompts, differential marketing, game-like features (commonly referred to as ‘‘gamification’’), and other design elements or features designed to engage retail investors when using a firm’s digital platforms (e.g., website, portal, app) 29 for services such as trading, robo-advice, and financial education. Our staff has observed that firms use technology to more efficiently develop investment strategies, including by using technology to automate their services, and to analyze the success of specific features and marketing practices at influencing retail investor behavior.30 Firms may also seek to fractional-share trading.’’); John Csiszar, How Our Approach to Investing Has Changed Forever, YAHOO! (Mar. 10, 2021), https://www.yahoo.com/ now/approach-investing-changed-forever190007929.html (‘‘Fractional share trading is just in its infancy but appears well on its way to changing how consumers approach investing. With fractional share trading, you can invest any dollar amount into stock, even if you don’t have enough to buy a single share . . . . Fractional share investing allows nearly anyone to get involved in the stock market without needing $100,000 or more to buy a properly diversified portfolio of individual stock names.’’). See also Staff Report on Equity and Options Market Structure Conditions in Early 2021 (Oct. 14, 2021), https://www.sec.gov/files/staffreport-equity-options-market-struction-conditionsearly-2021.pdf (‘‘Some brokers have sought to attract new customers by offering the ability to purchase fractional shares. Fractional shares give investors the ability to purchase less than 1 share of a stock.’’). Any staff statements represent the views of the staff. They are not a rule, regulation, or statement of the Commission. Furthermore, the Commission has neither approved nor disapproved their content. These staff statements, like all staff statements, have no legal force or effect: they do not alter or amend applicable law; and they create no new or additional obligations for any person. 28 See, e.g., Maggie Fitzgerald, Retail Investors Continue to Jump Into the Stock Market After GameStop Mania, CNBC (Mar. 10, 2021), https:// www.cnbc.com/2021/03/10/retail-investor-ranks-inthe-stock-market-continue-to-surge.html (providing year-over-year app download statistics for Robinhood, Webull, Sofi, Coinbase, TD Ameritrade, Charles Schwab, E-Trade, and Fidelity from 2018– 2020, and monthly figures for January and February of 2021); John Gittelsohn, Schwab Boosts New Trading Accounts 31% After Fees Go to Zero, Bloomberg (Nov. 14, 2019), https:// www.bloomberg.com/news/articles/2019-11-14/ schwab-boosts-brokerage-accounts-by-31-after-feescut-to-zero (noting that Charles Schwab opened 142,000 new trading accounts in October, a 31% jump over September’s pace). 29 Examples of DEPs include the following: social networking tools; games, streaks and other contests with prizes; points, badges, and leaderboards; notifications; celebrations for trading; visual cues; ideas presented at order placement and other curated lists or features; subscriptions and membership tiers; and chatbots. 30 See, e.g., SEC Investor Bulletin: Robo-Advisers (Feb. 23, 2017), https://www.sec.gov/oiea/investor- VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 lower expenses by replacing customer service personnel with chatbots that can address common customer questions, and outsourcing their back office operations to vendors that rely heavily on technology.31 The rate at which PDA-like technologies continues to evolve is increasing 32 and firms are exploring and deploying AI-based applications across different functions of their organizations, including customer facing, investment, and operational activities.33 These PDA-like technologies are complex and may include several categories of machine learning 34 algorithms, such as deep learning,35 supervised learning,36 unsupervised learning,37 and alerts-bulletins/ib_robo-advisers (discussing automated digital investment advisory programs); see also FINRA AI Report, supra note 9 (discussing three areas where broker-dealers are evaluating or using AI in the securities industry: communications with customers, investment processes, and operational functions). 31 See, e.g., SS&C Gets Automation Rolling with 180 ‘Digital Workers’, Ignites (Feb. 9, 2023), https:// www.ignites.com/c/3928224/508304?referrer_ module=searchSubFromIG&highlight=SS&C. 32 See, e.g., Robin Feldman and Kara Stein, AI Governance in the Financial Industry, 27 Stan. J.L. Bus. & Fin. 94, 122 (2022) (describing AI as ‘‘a technology that is rapidly evolving and capable of learning.’’). 33 See, e.g., Merav Ozair, FinanceGPT: The Next Generation of AI-Powered Robo Advisors and Chatbots (June 27, 2023), https://www.nasdaq.com/ articles/financegpt-the-next-generation-of-aipowered-robo-advisors-and-chatbots (describing current uses and development) (‘‘FinanceGPT’’). 34 FINRA described ‘‘Machine Learning (ML)’’ as ‘‘a field of computer science that uses algorithms to process large amounts of data and learn from it. Unlike traditional rules-based programming, [machine learning] models learn from input data to make predictions or identify meaningful patterns without being explicitly programmed to do so. There are different types of [machine-learning] models, depending on their intended function and structure[.]’’ See FINRA AI Report, supra note 9. 35 FINRA described a ‘‘deep learning model’’ as a model ‘‘built on an artificial neural network, in which algorithms process large amounts of unlabeled or unstructured data through multiple layers of learning in a manner inspired by how neural networks function in the brain. These models are typically used when the underlying data is significantly large in volume, obtained from disparate sources, and may have different formats (e.g., text, voice, and video).’’ See id. 36 FINRA described a ‘‘supervised machine learning’’ as a model that ‘‘is trained with labeled input data that correlates to a specified output. . . . The model is continuously refined to provide more accurate output as additional training data becomes available. After the model has learned from the patterns in the training data, it can then analyze additional data to produce the desired output . . . .’’ See id. 37 As described by FINRA, in unsupervised machine learning, ‘‘the input data is not labeled nor is the output specified. Instead, the models are fed large amounts of raw data and the algorithms are designed to identify any underlying meaningful patterns. The algorithms may cluster similar data but do so without any preconceived notion of the output . . . .’’ See id. PO 00000 Frm 00006 Fmt 4701 Sfmt 4702 reinforcement learning 38 processes.39 In the past few years, these PDA-like technologies have made increasing use of natural language processing and natural language generation.40 For example, AI has revolutionized chatbots by enabling them to understand and respond to natural language more accurately and learn and improve responses over time, leading to more personalized interactions with users. Recently, a new wave of online chatbots has rapidly moved machines using AI into new territory.41 Some of these chatbots have passed what is known as the ‘‘Turing test’’ and have become virtually indistinguishable from humans in particular situations.42 AI use is increasing year over year and in an array of applications.43 For instance, some robo-advisers use chatbots and NLP technology for their online platforms to provide investment advice and manage investment portfolios.44 These platforms may use a combination of AI, machine learning, NLP, and chatbot technologies to provide personalized investment recommendations to customers based on customer risk tolerance and investment goals. As a result of a growing desire to perform functions remotely and through automated means, the COVID–19 pandemic accelerated the adoption of certain PDA-like technologies.45 Many 38 As described by FINRA, in reinforcement learning, ‘‘the model learns dynamically to achieve the desired output through trial and error. If the model algorithm performs correctly and achieves the intended output, it is rewarded. Conversely, if it does not produce the desired output, it is penalized. Accordingly, the model learns over time to perform in a way that maximizes the net reward . . . .’’ See id. 39 See also FSB AI Report, supra note 9; Treasury RFI, supra note 9. 40 See, e.g., FINRA AI Report, supra note 9. 41 See Cade Metz, How Smart Are the Robots Getting?, The New York Times (Jan. 20, 2023, updated Jan. 25, 2023). 42 Id. The Turing test is a subjective test determined by whether the person interacting with a machine believes that they are interacting with another person. See id. 43 Embracing the Rapid Pace of AI, MIT Technology Review Insights (May 19, 2021), https:// www.technologyreview.com/2021/05/19/1025016/ embracing-the-rapid-pace-of-ai/. 44 See, e.g., FinanceGPT, supra note 33 (describing current uses and development). 45 See, e.g., Joe McKendrick, AI Adoption Skyrocketed Over the Last 18 Months, Harvard Bus. Rev. (Sept. 27, 2021), https://hbr.org/2021/09/aiadoption-skyrocketed-over-the-last-18-months (‘‘The [COVID–19] crisis accelerated the adoption of analytics and AI, and this momentum will continue into the 2020s, surveys show. Fifty-two percent of companies accelerated their AI adoption plans because of the Covid crisis, a study by PwC finds. Just about all, 86%, say that AI is becoming a ‘mainstream technology’ at their company in 2021. Harris Poll, working with Appen, found that 55% of companies reported they accelerated their AI strategy in 2020 due to Covid, and 67% expect to further accelerate their AI strategy in 2021.’’); E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 expect this momentum to continue, with AI becoming a mainstream technology across many industries, including the financial sector.46 Organizations, including firms in the securities industry,47 are using AI in a multitude of ways, including responding to customer inquiries, automating back-office processes, quality control,48 risk management, client identification and monitoring, selection of trading algorithms, and portfolio management.49 Others are actively developing investment advisory services based on PDA-like technologies.50 Further, recent advancements in data collection techniques have significantly enhanced the scale and scope of data analytics, and its potential applications. Due to increases in processing power and data storage capacity, a vast amount of data is now available for high-speed analysis using these technologies.51 KPMG, Thriving in an AI World: Unlocking the Value of AI Across Seven Key Industries (May 2021), at 5, https://advisory.kpmg.us/articles/2021/ thriving-in-an-ai-world.html (‘‘Thriving in an AI World’’); Blake Schmidt and Amanda Albright, AI Is Coming for Wealth Management. Here’s What That Means, Bloomberg Markets (Apr. 21, 2023), https://www.bloomberg.com/news/articles/2023-0421/vanguard-fidelity-experts-explain-how-ai-ischanging-wealth-management (discussing experts views on AI impact on the wealth management industry). 46 Id. 47 See IOSCO, The use of artificial intelligence and machine learning by market intermediaries and asset managers (Sept. 2021), at 1 (‘‘IOSCO AI/ML Report’’), iosco.org/library/pubdocs/pdf/ IOSCOPD684.pdf (‘‘Artificial Intelligence (AI) and Machine Learning (ML) are increasingly used in financial services, due to a combination of increased data availability and computing power. The use of AI and ML by market intermediaries and asset managers may be altering firms’ business models.’’). 48 See Thriving in an AI World, supra note 45; see also FINRA AI Report, supra note 9, at 5–10 (noting the use of AI in the securities industry for communications with customers, investment processes, and operational functions); FINRA, Deep Learning: The Future of the Market Manipulation Surveillance Program https://www.finra.org/mediacenter/finra-unscripted/deep-learning-marketsurveillance (‘‘FINRA’s Market Regulation and Technology teams recently wrapped up an extensive project to migrate the majority of FINRA’s market manipulation surveillance program to using deep learning in what is perhaps the largest application of artificial intelligence in the RegTech space to date.’’); Machine Learning and Market Manipulation, supra note 26; IOSCO AI/ML Report, id. 49 IOSCO AI/ML Report, supra note 47. 50 See, e.g., Hugh Son, JPMorgan is developing a ChatGPT-like A.I. service that gives investment advice, CNBC (May 25, 2023), https:// www.cnbc.com/2023/05/25/jpmorgan-develops-aiinvestment-advisor.html (discussing a trademark application filed by JPMorgan for a product called IndexGPT that will utilize ‘‘cloud computing software using artificial intelligence’’ for ‘‘analyzing and selecting securities tailored to customer needs[.]’’). 51 See, e.g., Dimitris Andriosopoulos et al., Computational Approaches and Data Analytics in VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 Furthermore, the range of data types has also expanded, with consumer shopping histories, media preferences, and online behavior now among the many types of data that data analytics can use to synthesize information, forecast financial outcomes, and predict investor and customer behavior.52 Consequently, these technologies can be applied in novel and powerful ways which may be subtle, such as using the layout of an app and choice of data presentation and formatting to influence trading decisions.53 Some trading apps use PDA and AI/machine learning along with detailed user data to increase user engagement and trading activity.54 Any risks of conflicts of interest associated with AI use will expand as firms’ use of AI grows. These risks will have broad consequences if AI makes decisions that favor the firms’ interests and then rapidly deploys that information to investors, potentially on a large scale.55 Firms’ nascent use of AI Financial Services: A Literature Review, 70 J. Operational Rsch. Soc. 1581 (2019), https://doi.org/ 10.1080/01605682.2019.1595193; James Lawler & Anthony Joseph, Big Data Analytics Methodology in the Financial Industry, 15 Info. Sys. Ed. J. 38 (July 2017), https://isedj.org/2017-15/n4/ISEDJv15n4p38. html. 52 Daniel Broby, The Use of Predictive Analytics in Finance, 8 J. Fin & Data Sci. 145 (Nov. 2022), https://doi.org/10.1016/j.jfds.2022.05.003; OECD, Artificial Intelligence, Machine Learning and Big Data in Finance: Opportunities, Challenges, and Implications for Policy Makers (2021), https:// www.oecd.org/finance/financial-markets/Artificialintelligence-machine-learning-big-data-infinance.pdf. 53 See, e.g., Sayan Chaudhury and Chinmay Kulkarni, Design Patterns of Investing Apps and Their Effects on Investing Behaviors (2021) (‘‘Chaudhury & Kulkarni’’), dl.acm.org/doi/ fullHtml/10.1145/3461778.3462008 (‘‘investing apps can be considered as technical and social choice architectures that influence investing behavior’’). 54 See, e.g., Alex McFarland, 10 ‘‘Best’’ AI Stock Trading Bots, Unite.AI (June 4, 2023), https:// www.unite.ai/stock-trading-bots/. 55 See, e.g., Robo-Advisors and the Fiduciary and Best Interest Standards, supra note 12 (stating that the impact of firm conflicts of robo-advisors ‘‘are arguably more detrimental than personal conflicts between an advisor and client because the number of clients impacted by the firm conflict is potentially exponentially higher.’’). See also AI in Asset Management, supra note 14 (‘‘AI can make wrong decisions based on incorrect inferences that have captured spurious or irrelevant patterns in the data. For example, ANNs [artificial neural networks] that are trained to pick stocks with high expected returns might select illiquid, distressed stocks.’’); FINRA AI Report, supra note 9, at 11–19 (noting that the use of AI ‘‘raises several concerns that may be wide-ranging across various industries as well as some specific to the securities industry. Over the past few years, there have been numerous incidents reported about AI applications that may have been fraudulent, nefarious, discriminatory, or unfair, highlighting the issue of ethics in AI applications.’’); FINRA AI Report, supra note 9, at 13 (‘‘Depending on the use case, data scarcity may limit the model’s analysis and outcomes, and could produce results that may be narrow and irrelevant. On the other hand, incorporating data from many PO 00000 Frm 00007 Fmt 4701 Sfmt 4702 53965 may already be exposing investors to these types of risks as well as others.56 We are concerned that firms will intentionally or unintentionally take their own interest into account in the data or software underlying the applicable AI, as well as the applicable PDA-like technologies, resulting in investor harm. Among other things, a firm may use these technologies to optimize for the firm’s revenue or to generate behavioral prompts or social engineering to change investor behavior in a manner that benefits the firm but is to the detriment of the investor. 3. Commission Protection of Investors as Technology Has Evolved As noted above, firms’ use of technology and subsequent adaptation incorporating emerging technologies are not new.57 At the same time, the Commission has addressed firms’ relationships with investors in a variety of ways to ensure investor protection as use of technology in those relationships has evolved over time.58 The proposal, thus, is consistent with the Commission’s practice of evolving our regulation in light of market and technological developments. Broker-dealers and investment advisers are currently subject to extensive obligations under Federal securities laws and regulations, and, in the case of broker-dealers, rules of selfregulatory organizations,59 that are different sources may introduce newer risks if the data is not tested and validated, particularly if new data points fall outside of the dataset used to train the model.’’). 56 See, e.g., FINRA AI Report, supra note 9, at 5 (‘‘The use of AI-based applications is proliferating in the securities industry[.]’’); Sophia Duffy and Steve Parrish, You Say Fiduciary, I Say Binary: A Review and Recommendation of Robo-Advisors and the Fiduciary and Best Interest Standards, 17 Hastings Bus. L.J. 3, at 26 (2021) (‘‘robo-advisors can be, and often are, intentionally programmed to favor the institution by making recommendations that favor the institution’s products, rebalance client portfolios in ways which will allow the institution to earn more fees, and otherwise make recommendations that benefit the firm’’). 57 See supra section I.B.2. 58 See infra note 114. 59 Any person operating as a ‘‘broker’’ or ‘‘dealer’’ in the U.S. securities markets must register with the Commission, absent an exception or exemption. See Exchange Act section 15(a), 15 U.S.C. 78o(a); see also Exchange Act sections 3(a)(4) and 3(a)(5), 15 U.S.C. 78c(a)(4) and 78c(a)(5) (definitions of ‘‘broker’’ and ‘‘dealer,’’ respectively). Generally, all registered broker-dealers that deal with the public must become members of FINRA, a registered national securities association, unless the broker or dealer effects transactions in securities solely on an exchange of which it is a member. See Exchange Act section 15(b)(8), 15 U.S.C. 78o(b)(8); see also 17 CFR 240.15b9–1 (providing an exemption from Section 15(b)(8)). FINRA is the sole national securities association registered with the SEC under Section 15A of the Exchange Act. Because this release is focused on broker-dealers that deal with E:\FR\FM\09AUP2.SGM Continued 09AUP2 53966 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 designed to promote conduct that, among other things, protects investors, including protecting investors from conflicts of interest.60 To the extent PDA-like technologies are used in investor interactions that are subject to existing obligations, those obligations apply. These obligations include, but are not limited to, obligations related to investment advice and recommendations; 61 general and specific requirements aimed at addressing certain conflicts of interest, including requirements to eliminate, mitigate, or disclose certain conflicts of interest; disclosure of firms’ services, fees, and costs; disclosure of certain business practices, advertising, communications with the public (including the use of ‘‘investment analysis tools’’); supervision; and obligations related to policies and procedures.62 In addition to these obligations, Federal securities laws and regulations broadly prohibit fraud by broker-dealers and investment advisers as well as fraud by any person in the offer, purchase, or sale of securities, or the public and are FINRA member firms (unless an exception applies), we refer to FINRA rules as broadly applying to ‘‘broker-dealers,’’ rather than to ‘‘FINRA member firms.’’ 60 See infra section III.C.3; Fiduciary Interpretation, supra note 8, at section II.C. (‘‘The duty of loyalty requires that an adviser not subordinate its clients’ interests to its own.’’); see also Reg BI Adopting Release, supra note 8, at section II.A.1. (The ‘‘without placing the financial or other interest . . . ahead of the interest of the retail customer’’ phrasing recognizes that while a broker-dealer will inevitably have some financial interest in a recommendation—the nature and magnitude of which will vary—the broker-dealer’s interests cannot be placed ahead of the retail customer’s interest’’). Additionally, broker-dealers often provide a range of services that do not involve a recommendation to a retail customer—which is required in order for Reg BI to apply—and those services are subject to general and specific requirements to address associated conflicts of interest under the Exchange Act, Securities Act of 1933, and relevant self-regulatory organization (‘‘SRO’’) rules as applicable. See also FINRA Report on Conflicts of Interest (Oct. 2013), at Appendix I (Conflicts Regulation in the United States and Selected International Jurisdictions) (‘‘FINRA Conflict Report’’), https://www.finra.org/sites/ default/files/Industry/p359971.pdf (describing broad obligations under SEC and FINRA rules as well as specific conflicts-related disclosure requirements under FINRA rules). 61 See, e.g., 17 CFR 240.15l–1(a)(1) (‘‘Exchange Act rule 15l–1(a)(1)’’) (requiring broker-dealers and their associated persons to act in the best interest of retail customers when making recommendations, without placing the financial or other interest of the broker-dealer or its associated person ahead of the interest of the retail customer). 62 Compliance with the proposed conflicts rules would not alter a broker-dealer’s or investment adviser’s existing obligations under the Federal securities laws. The proposed conflicts rules would apply in addition to any other obligations under the Exchange Act and Advisers Act, along with any rules the Commission may adopt thereunder, and any other applicable provisions of the Federal securities laws and related rules and regulations. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 in connection with the purchase or sale of securities. The Commission has long acted to protect investors against the harm that can come when a firm acts on its conflicts of interest.63 For example, the Commission has brought enforcement actions regarding an investment adviser’s fiduciary duty to its clients with respect to conflicts of interest.64 Similarly, the Commission has reinforced fraud protection for investors in pooled investment vehicles against conflicts of interest through rule 206(4)– 8.65 The Commission regulates investment adviser advertising and marketing practices to protect against, among others, adviser conflicts of interest that may taint such marketing, including through recent amendments adapting those protections in light of the evolution of practices and technologies.66 63 See infra section III.C. e.g., SEC Press Release, SEC Share Class Initiative Returning More Than $125 Million to Investors: Reflecting SEC’s Commitment to Retail Investors, 79 Investment Advisers Who SelfReported Advisers Act Violations Agree to Compensate Investors Promptly, Ensure Adequate Fee Disclosures (Mar. 11, 2019), https:// www.sec.gov/news/press-release/2019-28 (describing settled orders against 79 investment advisers finding that the settling investment advisers placed their clients in mutual fund share classes that charged 12b–1 fees when lower-cost share classes of the same fund were available to their clients without adequately disclosing that the higher cost share class would be selected; according to the SEC’s orders, the 12b–1 fees were routinely paid to the investment advisers in their capacity as brokers, to their broker-dealer affiliates, or to their personnel who were also registered representatives, creating a conflict of interest with their clients, as the investment advisers stood to benefit from the clients’ paying higher fees); SEC v. Sergei Polevikov, et al., Litigation Release No. 25475 (Aug. 17, 2022) (settled order) (final judgment against employee working as a quantitative analyst at two asset management firms ‘‘for perpetrating a front-running scheme that generated profits of approximately $8.5 million’’); SEC Brings Settled Actions Charging Cherry-Picking and Compliance Failures, Adm. Proc. File No. 3–20955 (Aug 10, 2022) (settled order) (alleged multi-year cherry-picking scheme of former investment adviser representative of registered investment adviser preferentially allocating profitable trades or failing to allocate unprofitable trades to a adviser’s personal accounts at the expense of the advisers client accounts). 65 17 CFR 275.206(4)–8; see, e.g., In re. Virtua Capital Management, LLC, et al., Advisers Act Release No. 6033 (May 23, 2022) (allegedly failing to disclose conflicts of interest and associated fees, and breaching fiduciary duty to multiple private investment funds) (settled order). 66 See Investment Adviser Marketing Release, supra note 19, at section I (‘‘The concerns that motivated the Commission to adopt the advertising and solicitation rules [in 1961 and 1979, respectively] still exist today, but investment adviser marketing has evolved with advances in technology. In the decades since the adoption of both the advertising and solicitation rules, the use of the internet, mobile applications, and social media has become an integral part of business communications. Consumers today often rely on these forms of communication to obtain 64 See, PO 00000 Frm 00008 Fmt 4701 Sfmt 4702 Likewise, broker-dealers have long been subject to Commission and SRO regulations and rules that govern their business conduct, including general and specific obligations to address conflicts of interest.67 For example, under existing antifraud provisions of the Exchange Act, a broker-dealer has a duty to disclose material adverse information to its customers.68 Indeed, the Commission has enforced a brokerdealer’s duty to disclose material conflicts of interest under the antifraud provisions.69 Broker-dealers are subject to specific FINRA rules aimed at addressing certain conflicts of interest.70 Moreover, in 2019 the Commission adopted Regulation Best Interest (‘‘Reg BI’’), which was designed to enhance the quality of broker-dealer recommendations to retail customers and reduce the potential harm to retail customers that may be caused by conflicts of interest,71 by requiring broker-dealers that make recommendations to retail customers to, among other things, establish, maintain, and enforce policies and procedures reasonably designed to identify and information, including reviews and referrals, when considering buying goods and services. Advisers and third parties also rely on these same types of outlets to attract and refer potential customers.’’). 67 See infra section III.C.3 68 A broker-dealer may be liable if it does not disclose ‘‘material adverse facts of which it is aware.’’ See, e.g., Chasins v. Smith, Barney & Co., 438 F.2d 1167, 1172 (2nd Cir. 1970); SEC v. Hasho, 784 F. Supp. 1059, 1110 (S.D.N.Y. 1992); In the Matter of RichMark Capital Corp., Exchange Act Release No. 48758 (Nov. 7, 2003) (Commission Opinion) (‘‘When a securities dealer recommends stock to a customer, it is not only obligated to avoid affirmative misstatements, but also must disclose material adverse facts of which it is aware. That includes disclosure of ‘adverse interests’ such as ‘economic self-interest’ that could have influenced its recommendation.’’) (citations omitted). 69 See, e.g., In re. Edward D. Jones & Co, Securities Act Release No. 8520 (Dec. 22, 2004) (settled order) (broker-dealer violated antifraud provisions of Securities Act and Exchange Act by failing to disclose conflicts of interest arising from receipt of revenue sharing, directed brokerage payments and other payments from ‘‘preferred’’ families that were exclusively promoted by brokerdealer); In re. Morgan Stanley DW Inc., Securities Act Release No. 8339 (Nov. 17, 2003) (settled order) (broker-dealer violated antifraud provisions of Securities Act by failing to disclose special promotion of funds from families that paid revenue sharing and portfolio brokerage). 70 FINRA rules establish restrictions on the use of non-cash compensation in connection with the sale and distribution of mutual funds, variable annuities, direct participation program securities, public offerings of debt and equity securities, investment company securities, real estate investment trust programs, and the use of non-cash compensation to influence or reward employees of others. See FINRA Rules 2310, 2320, 2331, 2341, 5110, and 3220. These rules generally limit the manner in which members can pay or accept noncash compensation and detail the types of non-cash compensation that are permissible. 71 See Reg BI Adopting Release supra note 8, at text accompanying n.21. E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 disclose, mitigate, or eliminate, conflicts associated with a recommendation, including conflicts of interest that may result through the use of PDA-like technology to make recommendations (Reg BI’s ‘‘Conflict of Interest Obligation’’).72 The Commission has and will continue to bring enforcement actions for violations of the Federal securities laws that entail the use of PDA-like technologies. However, the rapid acceleration of PDA-like technologies and their adoption in the investment industry,73 the additional challenges associated with identifying and addressing conflicts of interest resulting from the use of these new technologies, and the concerns relating to scalability, discussed above, reinforce the importance of ensuring our regulatory regime specifically addresses these issues. In particular, disclosure may be ineffective in light of, as discussed above, the rate of investor interactions, the size of the datasets, the complexity of the algorithms on which the PDA-like technology is based, and the ability of the technology to learn investor preferences or behavior, which could entail providing disclosure that is lengthy, highly technical, and variable, which could cause investors difficulty in understanding the disclosure. In light of these concerns, and the harm to investors that can result when firms act on conflicts of interest, we are proposing rules to address conflicts of interest associated with a firm’s use of PDA-like technologies when interacting with investors that are contrary to the public interest and the protection of investors. In particular, the recent and rapid expansion of PDA-like technologies in the context of investment-related activities, without specific oversight obligations tailored to the specific risks involved in their use, can lead to outcomes that financially benefit firms at the expense of investors. Such a harm to investors might include the use of PDA-like technologies that prompt investors to enroll in products or services that financially benefit the firm but may not be consistent with 72 17 CFR 240.15l–1(a)(2)(iii) (‘‘Exchange Act rule 15l–1(a)(2)(iii)’’). 73 See, e.g., Amy Caiazza, Rob Rosenblum, and Danielle Sartain, Investment Advisers’ Fiduciary Duties: The Use of Artificial Intelligence, Harvard Law School Forum on Corporate Governance (June 11, 2020), https://corpgov.law.harvard.edu/2020/ 06/11/investment-advisers-fiduciary-duties-the-useof-artificial-intelligence/ (‘‘Artificial intelligence (AI) is an increasingly important technology within the investment management industry.’’); FINRA AI Report, supra note 9, at 5 (‘‘The use of AI-based applications is proliferating in the securities industry and transforming various functions within broker-dealers.’’). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 their investment goals or risk tolerance, encourage investors to enter into more frequent trades or employ riskier trading strategies (e.g., margin trading) that will increase the firm’s profit at the investors’ expense, or inappropriately steer investors toward complex and risky securities products inconsistent with investors’ investment objectives or risk profiles that result in harm to investors but that financially benefit the firm. Due to the inherent complexity and opacity of these technologies as well as their potential for scaling, we are proposing that such conflicts of interest should be eliminated or their effects should be neutralized, rather than handled by other methods of addressing the conflicts, such as through disclosure and consent. Moreover, many of these technologies provide means—for example, A/B testing 74—to empirically assess the conflicts’ impact and thus to neutralize the effect of a conflict on investors. Further, reliance on scalable, complex, and opaque PDA-like technologies can result in operational challenges or shortcomings. For example, failure to identify and address conflicts that may be present in the PDA-like technology used to steer investors toward a product or service could result in a firm’s failure to identify the risks to investors of certain investing behaviors that place the firm’s interest ahead of investors’ interest as well as inadequate compliance policies and procedures that would assist the firm in curbing these practices. As a consequence, this could result in the failure to take sufficient steps to address the potentially harmful effect of those conflicts.75 For these additional reasons, we are proposing that such conflicts of interest be eliminated or their effects be neutralized, rather than handled by other methods of addressing the conflicts, such as through disclosure and consent. 74 A/B testing refers to running a learning model on two different datasets with a single change between the two, which can help identify causal relationships and, through understanding how changes affect outcomes, gain a better understanding of the functionality of a model. See Seldon, A/B Testing for Machine Learning (July 7, 2021) (‘‘Seldon’’), https://www.seldon.io/a-btesting-for-machine-learning. 75 See, e.g., William Shaw and Aisha S. Gani, Wall Street Banks Seizing AI to Rewire the World of Finance, Financial Review (June 1, 2023) (in discussing fiduciary duty obligation when using AI in finance quoting a law firm partner as saying: ‘‘How do you demonstrate to investors and regulators that you’ve done your duty when you’ve used an output without really knowing what the inputs are?’’). PO 00000 Frm 00009 Fmt 4701 Sfmt 4702 53967 4. Use of Predictive Data Technologies in Investor Interactions Firms may use PDA-like technologies to transform user interfaces and the interactions that investors have on digital platforms.76 For example, firms may collect data from a variety of internal sources (e.g., trading desks, customer account histories, and communications) and external sources (e.g., public filings, social media platforms, and satellite images) in both structured and unstructured formats,77 enabling them to develop an understanding of investor preferences and adapt the interface and related prompts to appeal to those preferences. Firms may use these tools to increase the quantity of information used to support investment ideas,78 leverage investor data to send targeted questionnaires to investors regarding evolving investment goals, identify which investors might be open to a new investment product, or identify which investors are most likely to stop using a firm’s services.79 We are concerned, however, that a firm’s use of PDA-like technologies when engaging or communicating with—including by providing information to, providing recommendations or advice to, or soliciting—a prospective or current investor could take into consideration the firm’s interest in a manner that places its interests ahead of investors’ interests and thus harm investors.80 For example, some members of the public have expressed concern that firms’ use of these PDA-like technologies encourages practices that are profitable for the firm but may increase investors’ costs, undermine investors’ performance, or expose investors to 76 See, e.g., FSB AI Report, supra note 9, at 14– 15 (chatbots are being introduced by a range of financial services firms, often in mobile apps or social media, and chatbots are ‘‘increasingly moving toward giving advice and prompting customers to act’’). 77 See FINRA AI Report, supra note 9, at 4. 78 See Deloitte, Artificial intelligence: The next frontier for investment management firms (Feb. 5, 2019), https://www.deloitte.com/global/en/ Industries/financial-services/perspectives/ai-nextfrontier-in-investment-management.html. 79 See Ryan W. Neal, Three Firms Where Artificial Intelligence is Helping with Financial Planning (Jan. 17, 2020), https://www.investmentnews.com/ artificial-intelligence-advisers-176541 (describing current uses of AI and their potential application to broker-dealers and investment advisers). 80 While the proposed rules apply more broadly to the use of covered technology in investor interactions, as discussed below, firms using covered technology to provide advice or make recommendations are subject to standards of conduct, among other regulatory obligations, that already apply to such advice or recommendations. See infra section III.C.3. The proposed conflicts rules would apply in addition to these standards of conduct and other regulatory obligations. E:\FR\FM\09AUP2.SGM 09AUP2 53968 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 unnecessary risks based on their individual investment profile, such as: (i) excessive trading,81 (ii) using trading strategies that carry additional risk (e.g., options trading and trading on margin), and (iii) trading in complex securities products that are more remunerative to the firm but pose undue risk to the investor.82 81 See, e.g., Comment Letter from Pace Investor Rights Clinic (Oct. 1, 2021) (‘‘Pace University Letter’’) (‘‘DEPs can lead investors to trade more frequently and more often than is in their best interest. For example, the push notification feature provides investors with live price updates. This intentionally prompts investors to check their portfolios after receiving the notification, which can lead them to make additional trades or spend more time on the platform than they would have otherwise. Traditionally, the goal of investing for most retail investors is to save for the long term. Frequently checking their portfolio may cause investors to make decisions not in line with the goal of long-term saving and generational wealth building.’’). See also, e.g., Feedback Flyer Response of Lincoln Li on S7–10–21 (Aug. 27, 2021) (‘‘I started half a decade ago following value investing practices. However, [online investment and trading apps], that I used for a short time got me into day trading and speculation more frequently. I ended up stopping using these apps because they took up so much time with little gain. I spent more time long term trading based off of proper market factors and evaluation. There’s a big concern to me, especially as a professional game designer, as to how gamification in life impacting subjects can have negative impact on society, culture and personal finances. I have friends who got into technical trading and day trading due to these apps, who talk more like gamblers than actual investors. It sets a very poor precedent for this industry and behavior.’’); Feedback Flyer Response of Richard Green on S7–10–21 (Sept. 25, 2021) (responding to a question about online trading and investment platforms: ‘‘[m]y broker rewards referrals by offering free stocks for each referral. I think this pulls new investors into trading, which makes a lot of money for the broker, as newer investors are more likely to trade too frequently or make mistakes.’’); Feedback Flyer Response of Joseph on S7–10–21 (Aug. 28, 2021) (‘‘[A trading app’s] user interface is set up in a way to subconsciously influence retail traders to trade more frequently and engage in riskier investment products (options) than the average amount.’’). 82 In Congressional hearings related to market events in January 2021, investor protection concerns were identified relating to the use of certain types of DEPs, including advertisements targeted towards specific groups of investors on digital platforms and game-like features on mobile apps. See Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide: Hearing Before the H. Comm. on Fin. Servs., 113th Cong. (2021), https:// financialservices.house.gov/calendar/eventsingle. aspx?EventID=407107; Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide, Part II: Hearing Before the H. Comm. on Fin. Servs., 113th Cong. (2021), https://financialservices.house.gov/calendar/ eventsingle.aspx?EventID=406268, Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide, Part III: Hearing Before the H. Comm. on Fin. Servs., 113th Cong. (2021), https://financialservices.house.gov/ calendar/eventsingle.aspx?EventID=407748; Who Wins on Wall Street? GameStop, Robinhood, and the State of Retail Investing: Hearing Before the S. Comm. On Banking, Hous., & Urban Affairs, 113th Cong. (2021), https://www.banking.senate.gov/ hearings/who-wins-on-wall-street-gamestoprobinhoodand-the-state-of-retail-investing. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 In some cases, the use of PDA-like technologies to place a firm’s interests ahead of investors’ interests could reflect an intentional design choice.83 In other cases, however, the actions that place a firm’s interests ahead of the interest of investors may instead reflect the firm’s failure to fully understand the effects of its use of PDA-like technologies or to provide appropriate oversight of its use of such technologies.84 For example, AI and other similar technology are only as good as the data upon which it is based. Corrupted or mislabeled data, biased data, or data from unknown sources, can undermine data quality, leading to skewed outcomes with opaque biases as well as unintended failures.85 While the risk of poor data quality or skewed data is not unique to AI, the ability of PDA-like technologies used in investor interactions to process data more quickly than humans, and the potential for technology to disseminate the resulting communications to a mass market, can quickly magnify conflicts of interest and any resulting negative effects on investors. Moreover, erroneous data considered by a firm’s algorithm could have the effect of optimizing for the firm’s interest over investors’ interest by, for example, relying on outdated, previously higher cost information of investment options sponsored by other firms but relying on updated, lower cost information of identical investment options sponsored by the firm. This could result in a recommendation, advice, or other investor interaction that favors the firm’s sponsored products and creates a conflict, regardless of whether the firm intentionally developed the algorithm to 83 See, e.g., Megan Ji, Note, Are Robots Good Fiduciaries? Regulating Robo-Advisors Under the Investment Advisers Act of 1940, 117 Colum. L. Rev. 1543, 1580 (Oct. 2017) (recommending that the Commission adopt regulations in which ‘‘roboadvisors, in their disclosures, clearly delineate between conflicts that are programmed into their algorithms and conflicts that may affect the design of algorithms.’’). 84 See Catherine Thorbecke, Plagued with errors: A news outlet’s decision to write stories with AI backfires, CNN (Jan. 23, 2023), https:// www.cnn.com/2023/01/25/tech/cnet-ai-tool-newsstories/. 85 See, e.g., Regulation Systems Compliance and Integrity, Release No. 34–97143 (Mar. 15, 2023) [88 FR 23146 (Apr. 14, 2023)] (describing the potential market impact of a corrupted data security-based swap data repository). See also National Institute of Science and Technology Special Publication 1270, Towards a Standard for Identifying and Managing Bias in Artificial Intelligence (Mar. 2022), at section 3.1 (describing dataset challenges resulting in AI bias, discrimination, and systematic gaps in performance); Thor Olavsrud, 7 famous analytics and AI disasters (Apr. 15, 2022), https:// www.cio.com/article/190888/5-famous-analyticsand-ai-disasters.html. PO 00000 Frm 00010 Fmt 4701 Sfmt 4702 optimize for its interest.86 Poor data quality or skewed data could not only limit the learning capability of an AI or machine learning system but could also potentially negatively impact how it makes inferences and decisions in the future,87 giving rise to erroneous or poor predictions, resulting in a failure to achieve the system’s intended objectives,88 and benefiting the firm over investors (whether intentionally or unintentionally). We have observed instances where conflicts of interest associated with a firm’s use of PDA-like technologies have resulted in harm to investors. A recent enforcement action involved allegations that an adviser marketed that its ‘‘no fee’’ robo-adviser portfolios were determined through a ‘‘disciplined portfolio construction methodology’’ when they allegedly were pre-set to hold a certain percent of assets in cash because the adviser’s affiliate was guaranteed a certain amount of revenue at these levels. The adviser allegedly did not disclose its conflict of interest in setting the cash allocations; that this conflict resulted in higher cash allocations, which could negatively impact performance in a rising market; and that the cash allocations were higher than other services because clients did not pay a fee.89 While the focus of that action was on the alleged disclosure failure, it also highlights the potential for PDA-like technologies to be used in ways that advance a firm’s interests at the expense of its investors’ interests. The proposed conflicts rules would require a firm to analyze its investor interactions that use PDA-like technology for the types of conflicts of interest that were at issue in that action in order to determine whether the investor interaction places the firm’s interests ahead of its investors’ interests and, if so, eliminate, or neutralize the effect of, the conflicts of interest on investors. In addition, the Commission’s 2021 Request for Information and Comments on Broker-Dealer and 86 In this example, it is also possible that erroneous data could result in the reverse effect, generating a recommendation in favor of a nonsponsored product when the firm’s sponsored product may be more cost-effective. This would not result in a conflict under the proposed rules but would nonetheless be subject to firms’ obligations under their respective regulatory regimes, including the applicable standard of conduct. 87 See Artificial Intelligence/Machine Learning Risk & Security Working Group (AIRS), Artificial Intelligence Risk & Governance, at 2.1.1 (accessed Apr. 18, 2023) (‘‘AIRS White Paper’’), https:// aiab.wharton.upenn.edu/research/artificialintelligence-risk-governance/. 88 Id. 89 In re. Charles Schwab & Co., Inc., et al., Exchange Act Release No. 95087 (June 13, 2022) (settled order). E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 Investment Adviser Digital Engagement Practices, Related Tools and Methods, and Regulatory Considerations and Potential Approaches (‘‘Request’’) 90 solicited comments related to conflicts of interest, among other areas.91 In response, the Commission received comments reflecting perceived conflicts of interest related to the use of online investing and trading applications, which some commenters indicated undermine their faith in the fairness of the markets.92 Failures to appropriately oversee these PDA-like technologies compound the risk that conflicts of interest may not be appropriately identified or managed. Due to the complexity and opacity of certain technologies, firms should have robust practices to appropriately oversee and understand their use and take steps 90 See Request for Information and Comments on Broker-Dealer and Investment Adviser Digital Engagement Practices, Related Tools and Methods, and Regulatory Considerations and Potential Approaches, Exchange Act Release No. 92766 (Aug. 27, 2021) [86 FR 49067 (Sept. 1, 2021)]. 91 See id., questions 1.26, 2.6, 3.5, 3.16, and 4.15. For additional discussion regarding the Request, see infra section I.B.5 92 See, e.g., Feedback Flyer Response of Tomas Liutvinas on S7–10–21 (Aug. 28, 2021) (‘‘It seems like there is no conflict of interest regulations in the US financial system. This makes me uneasy. Until the rights are fully explained, reported, and undone I will recommend to anyone I know to stay away from US markets. For myself, I’ve invested in a certain position with plans to leave the investment for the future generations of my family, to hold on hopefully up to a point when markets will be made transparent and fair.’’); Feedback Flyer Response of Jasper Pummell on S7–10–21 (Aug. 28, 2021) (‘‘I believe that online brokerages have a conflict of interest and financial regulation is needed to ensure that the markets are a safe place for retail traders.’’); Feedback Flyer Response of Robert on S7–10–21 (Aug. 27, 2021) (‘‘Retail needs a fair and transparent market. There are blantant [sic] conflicts of interest in the market which should be rectified immediately. Failure to do so will have a mass exodus of investors from the US stock market.’’). See also FINRA AI Report, supra note 9, at 11 (‘‘However, use of AI also raises several concerns that may be wide-ranging across various industries as well as some specific to the securities industry. Over the past few years, there have been numerous incidents reported about AI applications that may have been fraudulent, nefarious, discriminatory, or unfair, highlighting the issue of ethics in AI applications.’’). But see, e.g., Comment Letter from David Dusseault, President, Robinhood Financial, LLC (Oct. 1, 2021) (‘‘Robinhood Letter’’) (stating that conflicts of interest are not new to the financial industry and that the regulatory frameworks established by the SEC, such as Reg BI and the disclosure requirements of the Investment Advisers Act of 1940, rest on the principle that conflicts of interest exist, but investors are able to navigate them when they are adequately disclosed); Comment Letter from Investment Adviser Association (Oct. 1, 2021) (‘‘IAA Letter’’); Comment Letter from Kevin M. Carroll, Managing Director and Associate General Counsel, Securities Industry and Financial Markets Association (Oct. 1, 2021) (‘‘SIFMA Letter’’) (generally opposing new rules, guidance, or interpretations to address the use of digital engagement practices). These comments are all available in the comment file at https:// www.sec.gov/comments/s7-10-21/s71021.htm. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 to identify and appropriately address any associated conflicts of interest. For example, without appropriate personnel, a firm may not have the ability to modify the software or may lack the expertise to understand, monitor, or appropriately update code, limiting the firm’s ability to identify and appropriately address associated conflicts of interest. Furthermore, if the firm does not understand how the technology operates—including whether it takes into consideration the firm’s interest and how it can influence investor conduct—the firm may not fully understand whether, how, or the extent to which it is placing the firm’s interests ahead of investors’ interests. As a result of the complexity and opacity of PDA-like technologies, a firm needs different and specific practices to evaluate its use of the technology and recognize the risk of conflicts presented by that use compared to other practices. Without appropriate oversight and understanding of the conflicts of interest that could be amplified when the technology is incorporated into investor-facing interactions, such as design elements, features, or communications that nudge or prompt certain or more immediate action by an investor, investor harm can result. 5. Request for Information and Comment In August 2021, the Commission issued a request for information and public comment on the use of DEPs by broker-dealers and investment advisers, as well as the analytical and technological tools and methods used in connection with these DEPs.93 For purposes of the Request, the Commission defined DEPs broadly to include behavioral prompts, differential marketing, game-like features, and other design elements or features designed to engage retail investors.94 The Commission stated that DEPs may be designed to encourage account opening, account funding and trading, or may be designed solely to increase investor engagement with investing apps, as there may be value in the number of investors interacting with the platform, how often they visit, and how long they stay.95 The Request was issued in part to assist the Commission and its staff in better understanding the market practices associated with the use of DEPs by firms, facilitate an assessment of existing regulations and consideration of whether regulatory action may be needed to further the 93 See Request, supra note 90. id. at 49067. 95 See id. at 49069. 94 See PO 00000 Frm 00011 Fmt 4701 Sfmt 4702 53969 Commission’s mission in connection with firms’ use of DEPs, as well as to provide a forum for market participants (including investors), and other interested parties to share their perspectives on the use of DEPs and the related tools and methods, including potential benefits that DEPs provide to retail investors, as well as potential investor protection concerns.96 The Commission received over 2,300 public comments, including submissions provided through an online ‘‘feedback flyer’’ that accompanied the Request and was provided to better facilitate responses from retail investors.97 Commenters offered a wide range of perspectives on broker-dealers’ and investment advisers’ use of DEPs, addressing their purpose, providing information on how investors interact with them, and offering broad reflections on potential regulatory action. Commenters also provided views on benefits and risks related to firms’ use of DEPs, as well as the AI/machine learning and behavioral psychology that firms use to develop and deploy DEPs.98 A number of commenters also provided detailed feedback regarding the potential need for additional action to address the issues presented by DEPs and their underlying technology. For example, multiple commenters raised concerns over the risks of harm to investors if the Commission did not act, and requested that the Commission interpret existing regulations in a way 96 As noted in the Request, the market practices explored included: (i) the extent to which firms use DEPs; (ii) the types of DEPs most frequently used; (iii) the tools and methods used to develop and implement DEPs; and (iv) information pertaining to retail investor engagement with DEPs, including any data related to investor demographics, trading behaviors, and investment performance. See id. at 49068. 97 The ‘‘Feedback Flyer’’ was attached as Appendix A to the Request and asked individual investors to provide their comments with regard to online trading or investment platforms, such as websites and mobile applications, to provide the Commission with a better understanding of retail investors’ experiences on these platforms. The Feedback Flyer provided 11 different question prompts, with an array of both multiple choice, and free text response options whereby respondents could submit relevant comments. Comments received in response to the Request are available at https://www.sec.gov/comments/s7-10-21/ s71021.htm. 98 See, e.g., Comment Letter from American Securities Association (Sept. 30, 2021); Comment Letter from Securities Arbitration Clinic and Professor of Clinical Legal Education, St. John’s University School of Law Securities Arbitration Clinic, (Oct. 1, 2021) (‘‘St. John’s Letter’’); Comment Letter from Morningstar, Inc. and Morningstar Investment Management, LLC (Oct. 1, 2021) (‘‘Morningstar Letter’’); Comment Letter from James F. Tierney, Assistant Professor of Law, University of Nebraska College of Law (Oct. 1, 2021) (‘‘Tierney Letter’’); Pace University Letter; Comment Letter from Law Office of Simon Kogan, (Oct. 17, 2021) (‘‘Kogan Letter’’). E:\FR\FM\09AUP2.SGM 09AUP2 53970 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 that would apply to most DEPs and/or adopt additional regulations to address those risks.99 Many of these commenters suggested a need to address the standards of conduct applicable to broker-dealers and investment advisers when interacting with retail investors through digital platforms.100 Some of these commenters noted that Reg BI does not apply to firms with a selfdirected brokerage business model, including those that use DEPs 101 and provided additional suggestions that the Commission could take to address firms’ 99 See, e.g., Comment Letter from Scopus Financial Group (Sept. 20, 2021); Comment Letter from Better Markets, Inc. (Oct. 1, 2021) (‘‘Better Markets Letter’’); Comment Letter from Public Investors Advocate Bar Association (Oct. 1, 2021) (‘‘PIABA Letter’’); Comment Letter from University of Miami School of Law Investor Rights Clinic et al. (Oct 1, 2021) (‘‘University of Miami Letter’’); Comment Letter from Fidelity Investments (Oct. 1, 2021); St. John’s Letter; Morningstar Letter. We also considered views received from the SEC’s Investor Advisory Committee on ethical guidelines for artificial intelligence and algorithmic models used by investment advisers. See Investor Advisory Committee, Establishment of an Ethical Artificial Intelligence Framework for Investment Advisors (Apr. 6, 2023), https://www.sec.gov/files/20230406iac-letter-ethical-ai.pdf. 100 See, e.g., Pace University Letter (‘‘We believe that retail investors, particularly novice investors, believe that they are receiving advice or recommendations from DEPs. This includes the top mover list, analyst ratings, push notifications, and other DEPs that encourage investment activity. Many of our survey participants stated that they believe that these DEPs influenced their decisionmaking. At the same time, DEPs may also influence investor decision-making without investors being conscious of it.’’); Comment Letter from North American Securities Administrators Association (Oct. 1, 2021) (‘‘NASAA Letter’’) (‘‘To assist with compliance and to protect investors, the Commission should provide further guidance as to when DEP-based communications constitute recommendations. However, given the speed of technology, NASAA suggests that guidance should not be limited to any particular DEP, but rather should be focused on the effects of technologies on investor behavior generally.’’); Comment Letter from Fiduciary Insights and Practice Growth Partners (Sept. 30, 2021) (‘‘Aikin/Mindicino Letter’’) (‘‘[A]s the complexity and heterogeneity of wants, needs, and capabilities of the clientele rises, the sophistication and artificial intelligence and machine learning (AI/ML) of the DEPs must increase dramatically. Commensurately, the internal oversight and regulatory guardrails to assure that customer/client best interests are served must also increase.’’); see also Comment Letter from Morgan Stanley Wealth Management (Oct. 1, 2021) (‘‘Morgan Stanley Letter’’) (while noting existing protections, stating that ‘‘[s]hould the Commission believe additional guidance is necessary, we suggest the adoption of principles-based, technology neutral adjustments to the existing regulatory regime to address the fast evolving technological landscape’’); Better Markets Letter; University of Miami Letter (‘‘As the SEC continues its review of standards applicable to financial professional[s], it is critical to enhance investor protection in the fastgrowing and increasingly harmful digital platform environment.’’). 101 See, e.g., Robinhood Letter (‘‘The SEC acknowledged the benefits of a self-directed model such as Robinhood’s in adopting Reg BI, explicitly stating that Reg BI does not apply to this model.’’). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 use of DEPs.102 Others provided detailed opinions as to the application of an investment adviser’s fiduciary duty to DEPs.103 A significant number of commenters also addressed other laws and regulations and their sufficiency, or lack thereof, in their application to DEPs, including discussion addressing (i) antifraud and general standards of conduct; 104 (ii) regulation of advertising, marketing, and communications with the public; 105 (iii) compliance and supervision obligations; 106 (iv) data privacy and cybersecurity concerns; 107 (v) customer onboarding obligations; 108 (vi) Commission Staff’s 2017 Robo-Adviser Guidance; 109 and (vii) the Advisers Act recordkeeping rule.110 102 See, e.g., Pace University Letter (‘‘DEPs and online platforms have expanded access to the market to new investors, while at the same time influencing the decision-making of those investors—particularly novice investors—in ways that are often in conflict with their bests interest.’’); see also Tierney Letter; Better Markets Letter; SIFMA Letter; Morningstar Letter; Morgan Stanley Letter; University of Miami Letter (‘‘Due to the influential nature of DEPs, the SEC should enhance the Regulation Best Interest disclosure obligation and conflict of interest obligation by requiring firms to flag investor trades and/or positions where there is a likelihood that the firm will act in a manner adverse to the investor’s position and to notify investors of these potential actions.’’). 103 See, e.g., IAA Letter (‘‘Some advisers also use various analytical and technological tools to develop and provide investment advice, including through online platforms or as part of enhancing their in-person investment advisory services. Investment advisers may also engage in DEPs to develop and provide investor education and related tools.’’); see also Comment Letter from Envestnet Asset Management, Inc. (Oct. 1, 2021) (‘‘Envestnet Letter’’); Comment Letter from Julius LeimanCarbia, Chief Legal Officer, Wealthfront Corporation (Oct. 8, 2021) (‘‘Wealthfront Letter’’); NASAA Letter; Aikin/Mindicino Letter; Better Markets Letter; SIFMA Letter; University of Miami Letter; Morgan Stanley Letter. 104 See, e.g., Comment Letter from Jennifer Schulp, Director of Financial Regulation Studies, Center for Monetary and Financial Alternatives, CATO Institute (Oct. 1, 2021) (‘‘CATO Institute Letter’’); Comment Letter from Brandon Krieg, CEO, Stash Financial, Inc. and Stash Investments LLC (Oct. 1, 2021) (‘‘Stash Letter’’); Wealthfront Letter; IAA Letter; Robinhood Letter; SIFMA Letter; Tierney Letter. 105 See, e.g., PIABA Letter; CATO Institute Letter; IAA Letter. 106 See, e.g., Comment Letter from James J. Angel, Ph.D., CFP, CFA, Associate Professor of Finance, McDonough School of Business, Georgetown University (Sept. 30, 2021); IAA Letter; Stash Letter; Aikin/Mindicino Letter; PIABA Letter; CATO Institute Letter. 107 See, e.g., NASAA Letter; Envestnet Letter; Kogan Letter. 108 See, e.g., University of Miami Letter. 109 See, e.g., Comment Letter from Penny Lee, CEO, Financial Technology Association (Oct. 1, 2021); IAA Letter. 110 See, e.g., Comment Letter from Pamela Lewis Marlborough, Managing Director and Associate General Counsel, Teachers Insurance and Annuity Association of America (Oct. 1, 2021); SIFMA Letter; University of Miami Letter. PO 00000 Frm 00012 Fmt 4701 Sfmt 4702 C. Overview of the Proposal In view of Commission staff observations, our experience administering our existing rules, the discussion in section 1.B. above on the development of PDA-like technologies in firm investor interactions and the unique risks they raise regarding conflicts of interest, and comments received in response to the Request, we are proposing to update the regulatory framework to help ensure that firms are appropriately addressing conflicts of interest associated with the use of PDAlike technologies. Specifically, we propose that firms should be required to identify and eliminate, or neutralize the effect of, certain conflicts of interest associated with their use of PDA-like technologies because the effects of these conflicts of interest are contrary to the public interest and the protection of investors.111 Proposed rules 15l–2 under the Exchange Act (17 CFR 240.15l–2) and 211(h)(2)–4 under the Advisers Act (17 CFR 275.211(h)(2)–4) (collectively, the ‘‘proposed conflicts rules’’) are designed to address the conflicts of interest associated with firms’ use of PDA-like technology when engaging in certain investor interactions, and the proposed rules would do so in a way that aligns with (and in some respects may satisfy) firms’ existing regulatory obligations.112 Except as specifically noted, the texts of proposed conflicts rule applicable to brokers and dealers (17 CFR 240.15l–2) and the proposed conflicts rule applicable to investment advisers (17 CFR 275.211(h)(2)–4) would be substantially identical.113 The proposed conflicts rules would only apply where the firm uses defined covered technology—more specifically, an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes in an investor interaction. The proposal is designed to be sufficiently broad and principles-based to continue to be applicable as technology develops and to provide firms with flexibility to develop approaches to their use of technology consistent with their business model, subject to the over-arching requirement 111 See infra section II.A.2.e. id. 113 Citations herein to the ‘‘proposed conflicts rules’’ reference each of the proposed conflicts rules as they would be codified in each location. Citations to a particular section of the CFR reference only the proposed conflicts rule that would apply to broker-dealers or to investment advisers, as applicable. 112 See E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 that they need to be sufficient to prevent the firm from placing its interests ahead of investor interests. The proposal is also designed to be consistent with the Commission’s prior actions regarding technological innovation.114 We note that the staff has also provided their views on the industry’s expanding use of technology in the context of roboadvisers 115 and shared examination findings and risks associated with the 114 Historically, the Commission has reviewed the changing technology landscape, provided guidance, and if necessary amended its regulatory framework to protect investors while still allowing firms’ use of technology to innovate and benefit investors. See, e.g., Use of Electronic Media for Delivery Purposes, Release No. 7233 (Oct. 6, 1995) [60 FR 53458 (Oct. 10, 1995] (providing Commission views with respect to the use of electronic media for information delivery under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940); Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information, Exchange Act Release No. 37182 (May 9, 1996) [61 FR 24644 (May 15, 1996)] (‘‘1996 Release’’) (providing Commission views on electronic delivery of required information by broker-dealers, transfer agents and investment advisers); and Use of Electronic Media, Exchange Act Release No. 42728 (Apr. 28, 2000) [65 FR 25843 (May 4, 2000)] (‘‘2000 Release’’) (providing interpretive guidance on the use of electronic media to deliver documents on matters such as telephonic and global consent; issuer liability for website content; and legal principles that should be considered in conducting online offerings). In addition, the Commission has amended regulations to accommodate evolving technologies and changes in the way investors consume information. See, e.g., Tailored Shareholder Reports for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements, Investment Company Act Release No. 34731 (Oct. 26, 2022) (87 FR 72758 [Nov. 25, 2022]) (requiring layered disclosure for funds’ shareholder reports and graphical representations of fund holdings); Investment Adviser Marketing, Investment Advisers Act Release No. 5653 (Dec. 22, 2020) [86 FR 13024 (Mar. 5, 2021)] (adopting ‘‘principles-based provisions designed to accommodate the continual evolution and interplay of technology and advice,’’ and providing specific guidance regarding, among others, the use of social media). Further, the Commission has amended regulations to expand the use of electronic filing options by investment advisers and institutional investment managers and updated recordkeeping requirements to make them adaptable to new technologies in electronic recordkeeping. See, e.g., Electronic Submission of Applications for Orders under the Advisers Act and the Investment Company Act, Confidential Treatment Requests for Filings on Form 13F, and Form ADV–NR; Amendments to Form 13F, Advisers Act Release No. 6056 (June 23, 2022) [87 FR 38943 (June 30, 2022)]; see also Electronic Recordkeeping Requirements for Broker-Dealers, Security-Based Swap Dealers, and Major SecurityBased Swap Participants, Exchange Act Release No. 96034 (Oct. 12, 2022) [87 FR 66412 (Nov. 3, 2022)] (‘‘Electronic Recordkeeping Release’’). 115 See Robo-Advisers, Division of Investment Management Guidance Update No. 2017–02 (Feb. 2017) (‘‘2017 IM Guidance’’), https://www.sec.gov/ investment/im-guidance-2017-02.pdf (addressing among other things, presentation of disclosures, provision of suitable advice, and effective compliance programs). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 use of robo-advisory products,116 among other areas. The proposal draws upon our authority under section 211(h) of the Advisers Act and section 15(l) of the Exchange Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (‘‘Dodd-Frank Act’’) added section 211(h)(2) to the Advisers Act and section 15(l)(2) to the Exchange Act, each of which, among other things, authorizes the Commission to ‘‘promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors.’’ 117 The proposal is intended to be technology neutral. We are not seeking to identify which technologies a firm should or should not use. Rather, the proposal builds off existing legal standards and, as discussed throughout the release, is designed to address certain risks to investors associated with firms’ use of certain technology in their interactions with investors, regardless of which such technology is used.118 The proposal also is designed to permit firms the ability to employ tools that they believe would address these risks that are specific to the particular technology they use consistent with the proposal. The Commission has long acted to protect investors from the harms arising from conflicts of interests and will continually assess the harms and revise those protections in light of the evolution of practices, including with regard to firms’ use of technologies. As discussed in further detail below, conflicts associated with the use of PDA-like technologies should be eliminated or their effects neutralized 116 See Observations from Examinations of Advisers that Provide Electronic Investment Advice, Division of Examinations Risk Alert (Nov. 9, 2021) (‘‘2021 Risk Alert’’), https://www.sec.gov/ files/exams-eia-risk-alert.pdf (noting, ‘‘[n]early all of the examined advisers received a deficiency letter, with observations most often noted in the areas of: (1) compliance programs, including policies, procedures, and testing.’’). 117 See Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111– 203, 124 Stat. 1376 (2010). As noted in note 8 to subsection (l), another subsection (l) is set out after the first subsection (k) of the Exchange Act. 118 Firms’ use of PDA-like technology may also be subject to other potential legal and contractual restrictions on the ability for advisers and brokers to collect and use customer information. See, e.g., 17 CFR part 248, subpart A (Regulation S–P), requiring, among other things, brokers, dealers, investment companies, and registered investment advisers to adopt written policies and procedures for administrative, technical, and physical safeguards to protect customer records and information. PO 00000 Frm 00013 Fmt 4701 Sfmt 4702 53971 to protect investors from conflicts of interest associated with firms’ use of PDA-like technologies that results in investor interactions that place the interests of the firm and its associated persons ahead of investors’ interests. In particular, the proposed conflicts rules would generally require the following: • Elimination, or neutralization of effect of, conflicts of interest. The proposed conflicts rules would require a firm to (i) evaluate any use or reasonably foreseeable potential use by the firm or its associated person 119 of a covered technology in any investor interaction to identify any conflict of interest associated with that use or potential use; 120 (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 neutralize the effect of, those conflicts of interest that place the firm’s or its associated person’s interest ahead of the interest of investors. • Policies and procedures. The proposed conflicts rules would require a firm that has any investor interaction using covered technology to adopt, implement, and, in the case of brokerdealers, maintain, written policies and procedures reasonably designed to achieve compliance with the proposed conflicts rules, including (i) a written description of the process for evaluating any use (or reasonably foreseeable potential use) of a covered technology in any investor interaction; (ii) a written description of any material features of any covered technology used in any investor interaction and of any conflicts of interest associated with that use; (iii) a written description of the process for determining whether any conflict of interest identified pursuant to the proposed conflicts rules results in an investor interaction that places the interest of the firm or person associated with the firm ahead of the interests of the investor; (iv) 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 conflicts rules to result in an investor interaction that 119 As used in this release, the term ‘‘associated person’’ means, for investment advisers, a natural person who is a ‘‘person associated with an investment adviser’’ as defined in section 202(a)(17) of the Advisers Act and, for broker-dealers, a natural person who is an ‘‘associated person of a broker or dealer’’ as defined in section 3(a)(18) of the Exchange Act. 120 Covered technology, conflict of interest, investor interaction are each defined terms under the proposed rules. See proposed rules 211(h)(2)– 4(a) and 15l–2(a); see also infra sections II.A.1 and II.A.2.c. E:\FR\FM\09AUP2.SGM 09AUP2 53972 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules places the interest of the firm or associated person ahead of the interests of the investor; and (v) a review and written documentation of that review, no less frequently than annually, of the adequacy of the policies and procedures established pursuant to the proposed conflicts rules and the effectiveness of their implementation as well as a review of the written descriptions established pursuant to the proposed conflicts rules. Proposed amendments to applicable recordkeeping rules, rules 17a–3 and 17a–4 under the Exchange Act and rule 204–2 under the Advisers Act, would require firms to make and keep books and records related to the requirements of the proposed conflicts rules. These proposed amendments are designed to help facilitate the Commission’s examination and enforcement capabilities, including assessing compliance with the requirements of the proposed conflicts rules. The proposal is designed to prevent firms’ conflicts of interest from harming investors while allowing continued technological innovation in the industry. II. Discussion A. Proposed Conflicts Rules lotter on DSK11XQN23PROD with PROPOSALS2 1. Scope The proposed conflicts rules would apply only when a firm uses covered technology in an investor interaction. The proposed definitions are designed to identify those conflicts of interest that firms must evaluate to determine whether they result in investor interactions that place the firm’s interest ahead of investors’ interest and must therefore be eliminated or their effect neutralized.121 The proposed conflicts rules would apply to all broker-dealers and to all investment advisers registered, or required to be registered, with the Commission. a. Covered Technology The proposed conflicts rules would define covered technology as an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes.122 The proposed definition is designed to capture PDA-like technologies, such as AI, machine learning, or deep learning algorithms, neural networks, NLP, or large language 121 See supra section I.B.4 (describing existing technologies that may involve conflicts of interest) and infra section II.A.2.c (discussing the proposed definition of a conflict of interest). 122 Proposed conflicts rules at (a). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 models (including generative pretrained transformers), as well as other technologies that make use of historical or real-time data, lookup tables, or correlation matrices among others. The rate at which these technologies evolve has increased in recent years and may continue to increase.123 Accordingly, the proposed definition of covered technology is also designed to capture the variety of technologies and methods that firms currently use as well as those technologies and methods that may develop over time. The proposed definition would include widely used and bespoke technologies, future and existing technologies, sophisticated and relatively simple technologies, and ones that are both developed or maintained at a firm or licensed from third parties.124 The proposed definition, however, would be limited to those technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes. The use of these terms in the proposed conflicts rules is designed to capture a broad range of actions. This could include providing investment advice or recommendations, but it also encompasses design elements, features, or communications that nudge, prompt, cue, solicit, or influence investment-related behaviors or outcomes from investors. Investmentrelated behavior or outcomes can manifest themselves in many forms in addition to buying, selling, and holding securities, such as an investor making referrals or increasing trading volume and/or frequency. This broad proposed definition is designed to help ensure that, as innovation and technology evolve and firms expand their reliance on technologies to provide services to, 123 See e.g., Deloitte, Artificial intelligence: The next frontier for investment management firms (Feb. 5, 2019), https://www.deloitte.com/global/en/ Industries/financial-services/perspectives/ai-nextfrontier-in-investment-management.html (stating, for example, that ‘‘[f]irms have recognized a new opportunity to gain direct distribution to investors, benefit from enhanced efficiencies in servicing small accounts, and offer value-added services for advisors. This has translated into a wave of investment activity, with asset managers and intermediaries acquiring or investing in robo-advice technology.’’) See also Bob Veres and Joel Bruckstein, T3/Inside Information Advisor Software Survey (Mar. 14, 2023), https:// t3technologyhub.com/wp-content/uploads/2023/ 03/2023-T3-and-Inside-Information-SoftwareSurvey.pdf. 124 The SEC has proposed a new rule under the Advisers Act to prohibit registered investment advisers from outsourcing certain services or functions without first meeting minimum requirements. See Outsourcing by Investment Advisers, Investment Advisers Act Release No. 6176; File No. S7–25–22 (Oct. 26, 2022) [87 FR 68816 (Nov. 16, 2022)] (‘‘Proposed Outsourcing Rule’’). We encourage commenters to review that proposal to determine whether it might affect comments on this proposal. PO 00000 Frm 00014 Fmt 4701 Sfmt 4702 and to interact with, investors, our rules remain effective in protecting investors from the harmful impacts of conflicts of interest. The proposed definition would apply to the use of PDA-like technologies that analyze investors’ behaviors (e.g., spending patterns, browsing history on the firm’s website, updates on social media) to proactively provide curated research reports on particular investment products, because the use of such technology has been shown to guide or influence investment-related behaviors or outcomes. Similarly, using algorithmic-based tools, such as investment analysis tools, to provide tailored investment recommendations to investors would fall under the proposed definition of covered technology because the use of such tools is directly intended to guide investment-related behavior. As an additional example, a firm’s use of a conditional auto-encoder model to predict stock returns would be a covered technology.125 Similarly, if a firm utilizes a spreadsheet that implements financial modeling tools or calculations, such as correlation matrices, algorithms, or other computational functions, to reflect historical correlations between economic business cycles and the market returns of certain asset classes in order to optimize asset allocation recommendations to investors, the model contained in that spreadsheet would be a covered technology because the use of such financial modeling tool is directly intended to guide investment-related behavior. Likewise, covered technology would include a commercial off-the-shelf NLP technology that a firm may license to draft or revise advertisements guiding or directing investors or prospective investors to use its services. The proposed definition, however, would not include technologies that are designed purely to inform investors, such as a website that describes the investor’s current account balance and past performance but does not, for example, optimize for or predict future results, or otherwise guide or direct any investment-related action. Similarly, the proposed definition also would not include a technology that predicts whether an investor would be approved for a particular credit card issued by the firm’s affiliate based on other 125 An autoencoder return model is an unsupervised learning method that attempts to model a full panel of asset returns using only the returns themselves as inputs. See generally S. Gu, B. Kelly, and D. Xiu, Autoencoder Asset Pricing Models (Sept. 30, 2019), https://www.aqr.com/ Insights/Research/Working-Paper/AutoencoderAsset-Pricing-Models. E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules information the firm knows about the investor because the use of such technology does not, and is not intended to, affect an investment-related behavior or outcome. For the same reason, the use of a firm’s chatbot that employs PDA-like technology to assist investors with basic customer service support (e.g., password resets or disputing fraudulent account activity) would not qualify as covered technology under the proposed definition. We request comment on all aspects of the definition of covered technology, including the following items: 1. Is the scope of the proposed definition of a covered technology sufficiently clear? We intend for the proposed definition to cover PDA-like technologies; are there ways we could revise the proposed definition in order to better accomplish this? Are there any technologies covered by the proposed definition that go beyond PDA-like technologies and should be excluded? For instance, should the proposed definition distinguish between different categories of machine learning algorithms, such as deep learning, supervised learning, unsupervised learning, and reinforcement learning processes? Do one or more of these categories present more investor protection concerns related to conflicts of interest relative to other categories? Would firms be able to identify what would and would not be a covered technology for purposes of the proposed rules? If not, what additional clarity would be beneficial? We have described examples of technologies to which the definition would or would not apply. Should the definition be revised to include or specifically exclude such examples? 2. Would the definition adequately include the technology used by firms that would present the conflicts of interest and resulting risks to investors that these proposed rules are designed to address? If not, how should this definition be changed to further the objective of the proposed conflicts rules? Please explain your answer, including the extent to which these technologies do or do not present conflicts of interest risks to investors. Alternatively, do the technologies included in the proposed definition include technology that does not typically result in risks to investors that these proposed rules are designed to address? 3. Is the proposed definition of covered technology appropriately calibrated to allow for future technological developments? What adjustments, if any, should the Commission make to help ensure that VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 the definition of covered technology will remain evergreen despite future technological advancements? Conversely, what adjustments to the definition of covered technology, if any, are necessary to avoid covering those future technological advancements that do not possess characteristics that the proposed rules are intended to address? 4. The proposed definition of covered technology only applies to technologies that are used to optimize for, predict, guide, forecast, or direct investmentrelated behaviors or outcomes. Do the terms ‘‘optimize for,’’ ‘‘predict,’’ ‘‘guide,’’ ‘‘forecast,’’ and ‘‘direct’’ appropriately scope the definition? Is it clear what these terms are intended to capture or would further explanation be helpful? Are there certain technologies that would fit within one or more of those terms but which should be outside the scope of the proposed definition? Alternatively, are there certain technologies that would fall outside those terms but which should be within the scope of the proposed definition? If so, should we use additional or different words to clarify the meaning? For instance, should we include the term ‘‘influence’’ in the definition? If so, how would ‘‘influence’’ differ from the terms ‘‘guide’’ or ‘‘direct’’ in the definition? Should we use ‘‘nudge’’ or ‘‘prompt’’ in the definition? Alternatively, should we remove any of the terms in the proposed definition? For instance, are the terms ‘‘guide’’ and ‘‘direct’’ redundant or do they express distinct meanings within the context of the definition? Does ‘‘guide’’ capture broader activity than ‘‘direct’’ and cause the rule to capture technologies that should not be in scope? Should the definition be limited to technologies that direct or influence an investor? 5. Should the proposed definition of covered technology apply to technologies that are used to optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes, directly or indirectly? Are there certain PDA-like technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes indirectly that should be covered by this definition? If so, what are they and why? If the definition did include the term ‘‘indirectly,’’ would it include technologies that should not be covered by the proposed conflicts rules? 6. Should the definition of covered technology not include technology that is solely meant to inform investors, as proposed? 7. Does the term ‘‘covered technology’’ adequately reflect the definition? Should some other defined term be used, such as ‘‘covered PO 00000 Frm 00015 Fmt 4701 Sfmt 4702 53973 processes’’ or ‘‘covered methods’’? Are there any other terms that should be used? 8. Does the phrase ‘‘investmentrelated behaviors or outcomes’’ sufficiently clarify the intended scope of the rule and which technologies would not be within the definition? Is it clear what the phrase ‘‘investment-related behaviors or outcomes’’ would capture or would further explanation be helpful? Are there certain behaviors or outcomes that may not be ‘‘investment related’’ but should nonetheless be covered by the proposed definition? For instance, should PDA-like technologies used for back office or administrative functions, such as trade settlement, the routing of customers’ orders, accounting, or document review and processing, be included in the covered technology definition? Are commenters aware of any PDA-like technology that is used for back office functions, such as the routing of customer orders, that is also used to engage or communicate with investors (i.e., that involve an investor interaction)? Are there certain investment-related activities that may not be ‘‘behaviors or outcomes’’ that should be covered by the definition? Is either ‘‘behavior’’ or ‘‘outcome’’ overbroad, capturing activities beyond those intended by the definition? Should a different term, such as ‘‘investment-related covered technology’’ be used? 9. Are there aspects of this definition that should be broadened, narrowed, revised, removed, or added? For instance, should the definition be limited to the use of predictive data analytics and/or artificial intelligence that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes? Alternatively, should we limit the scope of the definition to technologies that are used to provide investment advice or recommendations? Should we otherwise limit the scope to technologies that are used directly by investors? Should we expressly exclude technologies that are not used by investors but instead are used by individuals who are associated with a firm and use the technologies in communicating with investors? b. Investor Interaction The proposed conflicts rules include definitions for both ‘‘investor’’ and ‘‘investor interaction.’’ 126 For brokers or dealers, the definition of investor would include a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or 126 See E:\FR\FM\09AUP2.SGM proposed conflict rules at (a). 09AUP2 53974 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 household purposes. The definition is designed to capture both prospective and current retail investors.127 For investment advisers, the definition of investor would include a client or prospective client, and any current or prospective investor in a pooled investment vehicle advised by the investment adviser.128 The use of PDAlike technology by investment advisers of pooled investment vehicles, such as algorithmically targeted advertisements that are designed to solicit investors in a pooled investment vehicle or algorithmically designed investment strategies in pooled investment vehicles, present the same investor protection concerns as advisers that use the same or similar technology to target or advise their advisory clients. Accordingly, we are proposing to define ‘‘investor’’ so that the proposed conflicts rules would broadly apply both to clients that receive investment advisory services from an investment adviser and to investors in a pooled investment vehicle advised by the investment adviser.129 The proposed conflicts rules would generally 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.130 This definition would capture a firm’s correspondence, dissemination, or conveyance of information to or solicitation of investors, in any form, including communications that take place in-person, on websites; via smartphones, computer applications, chatbots, email messages, and text 127 See supra note 6. Broker-dealers are subject to regulation under the Exchange Act and SRO rules, including a number of obligations that attach when a broker-dealer offers services to a retail customer, including making recommendations, as well as general and specific requirements aimed at addressing certain conflicts of interest. The application of these obligations can vary depending on a broker-dealer’s business lines and activities, as well as the level of customer sophistication. See Regulation Best Interest, Exchange Act Release No. 83062 (May 9, 2018) [83 FR 21574 (May 9, 2018)], at 21575 (‘‘Reg BI Proposing Release’’); see, e.g., FINRA Rule 2210 (applying broker-dealer obligations related to communications with the public differently to communications directed to retail versus institutional investors). Here, the focus of the proposed rules for broker-dealers is on retail investors. 128 See proposed rule 211(h)(2)–4(a) (specifying that ‘‘pooled investment vehicle’’ has the same meaning as in 17 CFR 275.206(4)–8, meaning any investment company as defined in section 3(a) of the Investment Company Act of 1940 or any company that would be an investment company under section 3(a) of that Investment Company Act but for the exclusion provided from that definition by either section 3(c)(1) or section 3(c)(7) of the Investment Company Act). 129 See proposed conflict rules at (a) (defining ‘‘Investor’’). 130 See proposed conflict rules at (a). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 messages; and other online or digital tools or platforms. This definition would include engagement between a firm and an investor’s account, on a discretionary or non-discretionary basis. This definition would also capture any advertisements, disseminated by or on behalf of a firm, that offer or promote services or that seek to obtain or retain one or more investors. The proposed definition is intended to be sufficiently broad to encompass the wide variety of methods, using current and future technologies, that firms could use to interact with investors.131 The proposed definition is generally designed to limit the proposed conflicts rules’ scope to a firm’s use of covered technology in interactions with investors. This aspect of the proposed conflicts rules recognizes that the conflicts associated with the use of covered technology in investor interactions present a higher risk of harm to investors than conflicts associated with technologies that are not used in such interactions. For instance, a firm could utilize covered technology to analyze historical data and current market data to identify trends and make predictions related to the firm’s intraday liquidity needs, peak liquidity demands, and working capital requirements. A firm could likewise use covered technology to make investment decisions about its own assets. Similarly, a firm could implement covered technology for automation of, for example, ‘‘back office’’ processes like the routing of customers’ orders 132 and accounting and trade settlement. In each of these examples, the use of covered technology for these processes does not involve an investor interaction, and therefore would not be subject to the proposed conflicts rules. In contrast, when a firm’s use or potential use of a covered technology in 131 See generally Investment Adviser Marketing Release, supra note 19 (a recent Commission rule designed to accommodate the continual evolution of the use of technology in the investment adviser industry as it relates to advisers marketing their services to clients and investors). 132 Although routing of customers’ orders is not covered by this proposal, broker-dealers owe their customers a duty of ‘‘best execution.’’ Best execution requires that a broker-dealer seek to obtain for its customer orders the most favorable terms reasonably available in the market under the circumstances. See, e.g., Newton v. Merrill, Lynch, Pierce, Fenner & Smith, 135 F.3d 266, 270 (3d Cir. 1998). See also Kurz v. Fidelity Management & Research Co., 556 F.3d 639, 640 (7th Cir. 2009); Geman v. SEC, 334 F.3d 1183, 1186 (10th Cir. 2003); see also FINRA Rule 5310 (Best Execution and Interpositioning). The Commission recently proposed a rule that, if adopted, would establish through Commission rule a best execution standard for broker-dealers. See Regulation Best Execution, Exchange Act Release No. 96496 (Dec. 14, 2022) [88 FR 5440 (Jan. 27, 2023)]. PO 00000 Frm 00016 Fmt 4701 Sfmt 4702 any investor interaction could involve a conflict of interest, a firm would be subject to the framework of the proposed conflicts rules. The proposed definition of investor interaction does not make any distinctions based on the manner in which an investor or the investor’s account interacts with the covered technology or on the manner in which the firm uses the technology in the interaction. Meaning, ‘‘use’’ of covered technology in an investor interaction can occur directly through the use of a covered technology itself (e.g., a behavioral feature on an online or digital platform that is meant to prompt, or has the effect of prompting, investors’ investment-related behaviors) or indirectly by firm personnel using the covered technology and communicating the resulting information gleaned to an investor (e.g., an email from a broker recommending an investment product when the broker used PDA-like technology to generate the recommendation).133 Unlike a purely ministerial or back office function, these examples involve an investment-related communication with an investor and would be considered an investor interaction under the proposed definition. Similarly, a firm may use covered technology to provide individual brokers or advisers with customized insights into an investor’s needs and interests and the broker or adviser may use this information to supplement their existing knowledge and expertise when making a suggestion to the investor during an in-person meeting. Such a scenario would result in the firm using a covered technology in an investor interaction under the proposed rules. An investor interaction would also include firms’ use of game-like prompts or marketing that ‘‘nudge’’ investors to take particular investment-related actions on digital platforms. In addition, the investor interaction definition covers solicitations, for example, a firm utilizing covered technology that scrapes public data, which the firm in turn uses to solicit clients through broadcast emails.134 133 To the extent a broker-dealer uses PDA-like technology to make a recommendation to a retail customer, the broker-dealer would also be subject to Reg BI and its attendant obligations, including the Conflict of Interest Obligation, as to the recommendation. Similarly, an investment adviser making a recommendation to its client would also be subject to fiduciary obligations that include a duty of loyalty under which an adviser must eliminate or make full and fair disclosure of all conflicts of interest. See Fiduciary Interpretation, supra note 8. 134 See infra section II.A.2.e (acknowledging that although a firm’s use of covered technology to solicit investors to open an account falls under the E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 The proposed definition of investor interaction would include interactions that have generally been viewed as outside the scope of ‘‘recommendations’’ for brokerdealers.135 For example, under the proposed definition, an investor interaction could include: firms’ use of research pages or ‘‘electronic libraries’’ to provide investors with the ability to obtain or request research reports, news, quotes, and charts from a firm-created website; or firm’s use of technologies to generate emails to investors as part of a firm-run email communication subscription that investors can sign up for and customize, and which alerts investors to items such as news affecting the securities in the investor’s portfolio or on the investor’s ‘‘watch list.’’ 136 Accordingly, the proposed definition would capture firm communications that may not rise to the level of a recommendation, yet are nonetheless designed to, or have the effect of, guiding or directing investors to take an investment-related action. The proposed definition would exclude from the investor interaction definition interactions solely for purposes of meeting legal or regulatory obligations.137 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. For example, the proposed definition would exclude interactions with investors solely for anti-money laundering purposes, such as using PDA-like technologies to identify and track investor activity for the purposes of flagging suspected fraudulent transactions and requesting identification and verification of the transaction from an investor (e.g., definition of an investor interaction, it may not involve a conflict of interest that would require elimination or neutralization under the proposed conflicts rules). On the other hand, a conflict of interest may appear if a firm’s chatbot is programmed to solicit only investors that scraped data show are heavy gamblers, and thus perceived as being more profitable to the firm as investors that might invest in risky, high-profit investments that earn the firm more money relative to other investments. 135 See NASD Notice to Members 01–23 (Apr. 2001) (Online Suitability—Suitability Rules and Online Communications) (discussing the types of online communications may constitute ‘‘recommendations’’ under the NASD suitability rule); Reg BI Adopting Release, supra note 8, at section II.B.2 (discussing factors to consider when determining whether a ‘‘recommendation’’ has been made by a broker-dealer). 136 See NASD Notice to Members 01–23, id. 137 See proposed conflicts rules at (a). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 sending two-factor authentication messages).138 If a firm, however, includes as part of such an interaction actions that are not reasonably designed to satisfy its obligations under applicable law (e.g., circulating a link to a digital platform that includes features designed to prompt investors to trade along with the annual delivery of Form ADV), and such additional actions are otherwise within the definition of an investor interaction, then such action would be considered an investor interaction for purposes of the proposed conflicts rules. In addition, the proposed definition would also exclude interactions solely for purposes of providing clerical, ministerial, or general administrative support. For example, the proposed definition would exclude basic chatbots or phone trees that firms use to direct customers to the appropriate customer service representative. This aspect of the exclusion is only intended to cover basic or first-level customer support designed to efficiently answer simple questions like providing the business hours of a branch office or the balance in the investor’s account, or to guide the investor to a human representative in the appropriate department of the firm who is trained to address the investor’s question. On the other hand, if a firm sought to employ a more advanced chatbot designed to answer complex investment-related questions, such as when or whether to invest in a particular investment product or security, this would no longer fit within the exclusion for clerical, ministerial, or general administrative support, and would constitute an investor interaction under the proposed definition. In either case, the exclusions would be limited to interactions that are ‘‘solely for the purpose’’ of the relevant category (or categories) of conduct in order to help ensure that interactions that serve several purposes, including purposes that are not excluded, will be within the scope of the definition of investor interaction.139 The ‘‘solely for 138 The activities covered under this legal and regulatory obligation exception would qualify as an investor interaction that uses covered technology absent this exception. However, as a practical matter, many of these activities would not involve a firm’s use of covered technology under the proposed definition, because such activities would not involve an analytical, technological, or computation function, algorithm, model, correlation matrix, or similar method or process (e.g., delivery of Form ADV or summary prospectus pursuant to legal obligations). 139 Interactions that are for the purpose of both categories of conduct would also fit within the exclusion. For example, an algorithm whose purpose was both to comply with legal or regulatory obligations and to conduct other clerical, ministerial, or general administrative support PO 00000 Frm 00017 Fmt 4701 Sfmt 4702 53975 the purpose’’ language is designed to help ensure that all the functions of a dual-use technology like a chatbot would be considered when evaluating conflicts of interest associated with use of the chatbot. We request comment on all aspects of the proposed definitions of investor interaction and investor, including the following items: 10. For broker-dealers, the proposed definition of investor means a natural person, or the legal representative of such natural person, who seeks to receive or receives services from the broker-dealer primarily for personal, family or household purposes. Should we narrow the definition of investor as applied to broker-dealers to only cover retail customers, as defined under Reg BI? Should we expand the definition of investor for brokers or dealers to cover all current and prospective investors and not just retail investors? We have stated that investors may not be able to understand the complexities of covered technologies and any conflicts associated with their use. Should we expand the definition of investor for broker-dealers to cover a certain subset of non-retail investors? The proposed definition of investor for investment advisers is not limited to services ‘‘primarily for personal, family or household purposes.’’ Should we add such limitation in the investment adviser conflicts rule? 11. Should we narrow the definition of investor for investment advisers? For example, should we only apply it to retail investors, as defined in Form CRS? If so, please explain why in comparison to other rules under the Advisers Act. 12. For investment advisers, the proposed definition of investor also includes investors or prospective investors in a pooled investment vehicle that is a client or prospective client of the investment adviser; should we retain this in the final rules? Are there special considerations for investors in a pooled investment vehicle that cause them to need less protection from conflicts of interest associated with a firm’s use of covered technology? If the definition of ‘‘investor’’ continues to include investors in pooled investment vehicles, as proposed, are there certain structures or types of pooled investment vehicles that should not be included? For example, should investors in collateralized loan obligation vehicles be excluded? Are there unique characteristics of such vehicles, functions would fit within the exclusion so long as the algorithm did not also have a third purpose that was not excluded from the definition. E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 53976 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules investors, or investors in other pooled investment vehicles, which make the additional protections that would be provided by the proposed conflicts rules unnecessary? The proposed definition of ‘‘investor’’ would incorporate the definition of ‘‘pooled investment vehicle’’ in rule 206(4)–8. Should we define the term ‘‘pooled investment vehicle’’ (or use another term)? Should we define the term more broadly for purposes of this rule to include other vehicles to which an investment adviser may provide investment advice that rely on other exclusions from the definition of investment company, such as companies primarily engaged in holding mortgages that are excluded pursuant to section 3(c)(5)(C) of the Investment Company Act, or collective investment trust funds or separate accounts excluded under section 3(c)(11) of the Investment Company Act? 13. Will the proposed definition of investors present challenges for firms that are dually registered as investment advisers and broker dealers? 14. Should we define ‘‘prospective investor’’ in the proposed rules? If so, how should we define this term and why? For example, should we define ‘‘prospective investor’’ as any person or entity that engages in some way with a firm’s services (e.g., downloads the firm’s mobile app, visits the firm’s website, or creates a log-in)? If not, should we provide guidance regarding how firms can identify prospective investors? 15. Is the proposed definition of investor interaction sufficiently clear? Would firms be able to identify what would be an investor interaction for purposes of the proposed conflicts rules? Are there activities that are not covered by the proposed definition of investor interaction that should be? Are there activities that are covered by the proposed definition that should not be? For instance, should a firm soliciting prospective investors be included within the definition? Should the proposed definition be limited to interactions in which investors directly interact with, or otherwise directly use, covered technology? Do situations in which investors do not directly interact with covered technology raise the same concerns of scalability as those in which investors do interact directly? 16. Do commenters agree that investor interactions, as proposed, may entail conflicts of interest that are particularly likely to result in investor harm or to take additional effort to discern? Are there types of activities we should specifically include or exclude within the definition? VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 17. Do commenters agree that the definition of investor interaction should exclude interactions solely for purposes of meeting legal or regulatory obligations or providing clerical, ministerial, or general administrative support? Should we remove any or all aspects of these exclusions from the definition in the final conflicts rules? In the case of interactions solely for the purpose of meeting legal or regulatory obligations, should we broaden or narrow the exclusion? For example, should we take into account legal or regulatory obligations as a result of compliance with foreign law, or with policies, rules, or directives of SROs (including securities exchanges) or other bodies? Generally, would investor interactions that fall under the proposed exclusions employ covered technology (e.g., technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes)? If so, how? If not, is the exception for legal or regulatory obligations additive? Is the exclusion for providing clerical, ministerial, or general administrative support sufficiently clear? For instance, is it clear this phrasing would capture trade settlement and the routing of customers’ orders or would further explanation be helpful? 18. Do the proposed conflicts rules adequately address how a firm would treat a single covered technology that features functions that are both included and excluded from the investor interaction definition? For instance, a chatbot that is used for both general customer support help (e.g., password resets) and to provide more advanced functions, such as guiding an investor as to when and whether to invest in a particular investment product. Should the proposed conflicts rules treat these dual-purpose covered technologies differently than covered technology used solely for purposes of meeting legal or regulatory obligations or providing clerical, ministerial, or general administrative support? 19. To the extent we retain or expand the exclusions, are there any conditions we should add in order for a firm to be able to rely on particular exclusions? For example, should we require that a firm create and maintain a written record if it relies on an exclusion? Are there other activities that should be excluded? For example, should we provide a more principles-based exclusion for certain activities that the firm affirmatively identifies in writing as low-risk and that are already part of existing compliance programs or subject to other laws, rules, regulations, or policies? PO 00000 Frm 00018 Fmt 4701 Sfmt 4702 20. As specified in the proposed definition of investor interaction, the definition would include discretionary management of accounts where the engagement is with the investor’s account, even if there is no communication or other interaction with investors themselves at the time of trades in their accounts. Should the discretionary management of accounts be included within the definition of investor interaction? Should it be excluded? Do commenters agree that a firm’s discretionary management of accounts using covered technologies may entail conflicts of interest that are particularly likely to result in investor harm and are not sufficiently addressed under the current applicable legal framework? Why or why not? 2. Identification, Determination, and Elimination, or Neutralization of the Effect of, a Conflict of Interest The proposed conflicts rules would require a firm to eliminate, or neutralize the effect of, certain conflicts of interest associated with the use of a covered technology in investor interactions.140 The proposed conflicts rules would also require firms to take affirmative steps as a precursor to eliminating or neutralizing the effect of these conflicts. First, a firm would be required to evaluate any use or reasonably foreseeable potential use of a covered technology in any investor interaction to identify whether it involves a conflict of interest, including through testing the technology. Second, a firm would be required to determine if any such conflict of interest results in an investor interaction that places the interest of the firm or an associated person ahead of investors’ interests. Third, the proposed conflicts rules would require a firm to take a particular action—elimination or neutralization—to address any conflict of interest the firm determines in step two results in an investor interaction that places its or an associated person’s interest ahead of investors’ interests.141 The proposed conflicts rules thus supplement, rather than supplant, existing regulatory obligations related to conflicts of interest, laying out particular steps a firm must take to address conflicts of interest arising specifically from the use of covered technologies in investor interactions.142 140 See infra section II.A.2.e. the application to interests of associated persons, see infra sections II.A.2.c, II.A.2.d, and II.A.2.e, and proposed conflicts rules at (b)(2) and (3). 142 The elimination or neutralization requirement of the proposed rules applies only to a narrower, defined subset of the broader universe of conflicts— those conflicts that a firm determines actually place 141 On E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules This is because the nature of these technologies (for example due to their inherent complexity and ability to rapidly scale transmission of conflicted actions across a firm’s investor base) requires additional steps to address conflicts associated with their use in investor interactions, compared to conflicts of interest more generally. lotter on DSK11XQN23PROD with PROPOSALS2 a. Evaluation and Identification The proposed conflicts rules would require a firm to evaluate any use or reasonably foreseeable potential use by the firm or its associated persons of a covered technology in any investor interaction to identify any conflict of interest associated with that use or potential use.143 This requirement of the proposal, in connection with the requirement to test and periodically retest any covered technology, is designed to help ensure that a firm has a reasonable understanding of whether its use or reasonably foreseeable potential use of the covered technology in investor interactions would be associated with a conflict of interest. The proposed conflicts rules do not mandate a particular means by which a firm is required to evaluate its particular use or potential use of a covered technology or identify a conflict of interest associated with that use or potential use. Instead, the firm may adopt an approach that is appropriate for its particular use of covered technology, provided that its evaluation approach is sufficient for the firm to identify the conflicts of interest that are associated with how the technology has operated in the past (for example, based on the firm’s experience in testing or based on research the firm conducts into other firms’ experience deploying the technology) and how it could operate once deployed by the firm. If a technology could be used in a variety of different scenarios, the firm should consider those scenarios in which it intends that the technology be used (and for which it is conducting the identification and evaluation process). It should also consider other scenarios that are reasonably foreseeable unless the firm has taken reasonable steps to prevent use of the technology in scenarios it has not approved (for the interests of the firm or certain associated persons ahead of the interests of investors. This is in contrast to, for example, an investment adviser’s fiduciary duty, which encompasses any interest that might incline the adviser, consciously or subconsciously, to provide advice that is not disinterested., or similarly in contrast to the broader universe of conflicts covered by Reg BI. Other conflicts of interest that only might affect the firm’s investor interactions would continue to be subject to these other obligations, as applicable. 143 See proposed conflicts rules at (b)(1). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 example, by limiting the personnel who are able to access the technology). A firm could adopt different approaches for different covered technologies.144 Such approaches could vary depending on the nature of the covered technologies employed by the firm at the time they are implemented, how the technologies are used, and the firm’s plans for future use of those technologies. For example, a firm that only uses simpler covered technologies in investor interactions, such as basic financial models contained in spreadsheets or simple investment algorithms, could take simpler steps to evaluate the technology and identify any conflicts of interest, such as requiring a review of the covered technology to confirm whether it weights outcomes based on factors that are favorable for the adviser or brokerdealer, such as the revenue generated by a particular course of action.145 Even when a firm identifies a conflict of interest associated with a simple covered technology, depending on the facts and circumstances, it may determine that such conflict of interest does not actually result in the firm’s or an associated person’s interests being placed ahead of those of investors, and that the conflict of interest does not need to be eliminated or its effects to be neutralized. Firms that use more advanced covered technologies may need to take additional steps to evaluate technology adequately and identify associated conflicts adequately.146 For example, a firm might instruct firm personnel with sufficient knowledge of both the applicable programming language and the firm’s regulatory obligations to review the source code of the technology, review documentation 144 Cf. U.S Chamber of Commerce Technology Engagement Center, Report of the Commission on Artificial Intelligence Competitiveness, Inclusion, and Innovation (Mar. 9, 2023), at 82 (‘‘Chamber of Commerce AI Report’’), https:// www.uschamber.com/assets/documents/CTEC_ AICommission2023_Report_v6.pdf (calling for ‘‘impact assessments’’ to help categorize potentially harmful uses of certain technologies in a risk-based framework). 145 See infra section II.A.2.d, discussing financial models. 146 These steps could be included in the policies that the firm would be required to adopt under the proposed conflicts rules, and may also be necessary to satisfy the proposed recordkeeping amendments. See infra section II.A.3 and II.B. A written description of a covered technology prepared in accordance with policies and procedures that are reasonably designed to prevent violation by the firm of the proposed conflicts rules generally should include a written evaluation of the technology and identify any conflicts of interest presented by the technology. This would also assist the firm in preparing records that would comply with the proposed recordkeeping amendments. See infra section II.B. PO 00000 Frm 00019 Fmt 4701 Sfmt 4702 53977 regarding how the technology works, and review the data considered by the covered technology (as well as how it is weighted).147 A firm seeking to evaluate an especially complex covered technology and identify conflicts of interest associated with its use may consider other methods as well. For example, if a firm is concerned that it may not be possible to determine the specific data points that a covered technology relied on when it reached a particular conclusion, and how it weighted the information, the firm could build ‘‘explainability’’ features into the technology in order to give the model the capacity to explain why it reached a particular outcome, recommendation, or prediction.148 By reviewing the output of the explainability features, the firm may be able to identify whether use of the covered technology is associated with a conflict of interest.149 Developing this capability would require an understanding of how the model operates and the types of data used to train it. Not all of these steps would be necessary (or possible) in all circumstances. So long as the firm has taken steps that are sufficient under the circumstances to evaluate its use or reasonably foreseeable potential use of the covered technology in investor interactions and identify any conflicts of interest associated with that use or potential use, this aspect of the proposed conflicts rules would be satisfied. To the extent a technology is customizable, we anticipate a firm will be able to evaluate the technology and identify the conflicts associated with its use through the choices it makes when customizing the technology. For 147 When evaluating the data considered by a covered technology used by a firm, both the data itself and the weighting of the data may inform a firm’s determination of whether or not any conflict of interest it identifies and evaluates would result in an investor interaction that places the interest of the firm ahead of the interests of investors. See infra section II.A.2.d. 148 See supra section I.B.4 (describing complex or opaque technologies, sometimes referred to as ‘‘black boxes’’). 149 Testing (such as A/B testing) that is designed to determine the influence of a particular factor may also be helpful and is discussed infra. If the output of the explainability features is not sufficient for the firm to identify whether a conflict of interest exists at all, the firm may still be able to use the output to determine that any conflict of interest that may exist still does not result in its interests being placed ahead of investors’ interests, or alternatively that any conflicts of interest that may exist have been eliminated or their effect has been neutralized due to controls the firm placed on its use of the technology. See infra section II.A.2.d (discussing using explainability features for determination) and infra section II.A.2.e (discussing using explainability features for elimination or neutralization). E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 53978 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules technologies that are not customizable, we anticipate a firm will be able to evaluate the technology and identify conflicts via other means. For example, a firm that licenses a covered technology from a third party may have no access, or limited access, to the underlying source code of the technology. In such circumstances, provided that the other documentation regarding how the technology functions is sufficiently detailed as to how the technology works, the identification and evaluation could be satisfied through review of such documentation. Firms without access to the underlying source code could review, for example, documentation about how the technology can be tailored to its investors’ requirements (such as how to tailor it to eliminate, or neutralize the effect of, conflicts of interest). In circumstances where the firm is relying only on the technology’s documentation, its testing methodology would be of special importance to help the firm discover whether there is any undocumented functionality that could be associated with a conflict of interest. When evaluating a covered technology and identifying conflicts of interest, a firm should consider the circumstances in which a covered technology would be deployed in investor interactions. Firms that use a covered technology in investor interactions that operates autonomously or with limited involvement by firm personnel should consider subjecting it to more scrutiny because the firm’s personnel may not immediately notice if the conflicts become apparent once the technology is deployed, or if its outputs change over time.150 On the other hand, if a covered technology is only used to provide first drafts of marketing materials, or is only used to provide investment ideas that will be more fully considered by firm personnel who are trained on the firm’s compliance policies, and the drafts or ideas are subjected to scrutiny throughout the review process before the output is ultimately used in an investor interaction, the covered technology generally may need comparatively less scrutiny. In certain cases, it may be difficult or impossible to evaluate a particular covered technology or identify any conflict of interest associated with its use or potential use within the meaning of the proposed rules. For example, 150 This tendency would also mean that the technology would need to be tested on a more frequent basis. See infra section II.A.2.b (discussing proposed testing requirement as it would apply to technologies that ‘‘drift’’ or that operate autonomously). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 many large language models may consider millions of different data points, which could make it difficult for a firm to determine whether certain of those data points implicate the firm’s interest. In some cases, it may be difficult for the firm to understand exactly what is in the data set that the model is considering, for example, if it was trained on a data set from the entire internet. Likewise, there may be situations where a firm does not have full visibility into all aspects of how a covered technology functions, such as if the firm licensed it from a third party.151 However, a firm’s lack of visibility would not absolve it of the responsibility to use a covered technology in investor interactions in compliance with the proposed conflicts rules. The Commission is aware that some more complex covered technologies lack explainability as to how the technology functions in practice, and how it reaches its conclusions (e.g., a ‘‘black box’’ algorithm where it is unclear exactly what inputs the technology is relying on and how it weights them). The proposed conflicts rules would apply to these covered technologies, and firms would only be able to continue using them where all requirements of the proposed conflicts rules are met, including the requirements of the evaluation, identification, testing, determination, and elimination or neutralization sections. For example, as a practical matter, firms that use such covered technologies likely may not meet the requirements of paragraph (b) of the proposed conflicts rules where they are unable to identify all conflicts of interest associated with the use of such covered technology. However, in such cases, firms may be able to modify these technologies, for example by embedding explainability features into their models and adopting back-end controls (such as limiting the personnel who can use a technology or the use cases in which it could be employed) in 151 FINRA has stated that outsourcing an activity or function to a third-party vendor does not relieve broker-dealers of their supervisory obligations, which must be reasonably designed to achieve compliance with Federal securities laws and regulations, as well as FINRA rules. See Vendor Management and Outsourcing, FINRA Regulatory Notice 21–29 (Aug. 13, 2021), https:// www.finra.org/sites/default/files/2021-08/ Regulatory-Notice-21-29.pdf. We also recently proposed a rule that, if adopted, would govern outsourcing by investment advisers of certain covered functions, and would in certain cases require investment advisers to obtain reasonable assurances that third parties could meet certain standards required by the Advisers Act and the rules thereunder. See Proposed Outsourcing Rule, supra note 124. PO 00000 Frm 00020 Fmt 4701 Sfmt 4702 a manner that will enable firms to satisfy these requirements. We request comment on all aspects of the proposed conflict rules’ identification and evaluation requirement, including the following items: 21. Do the proposed conflicts rules’ identification and evaluation requirements complement, overlap with, or duplicate the existing regulatory framework for broker-dealers and investment advisers? If so, in what ways? Specifically, would firms’ compliance with those other regulatory requirements contribute to compliance with the proposed conflicts rules, and vice versa? 22. Is the proposed requirement that a firm evaluate any use or reasonably foreseeable potential use of a covered technology to identify any conflict of interest associated with that use or potential use sufficient for a firm to understand how it should comply with the proposed conflicts rules? Should firms only be required to evaluate a technology used in investor interactions and identify associated conflicts of interest if they reasonably believe their use (or potential use) of the technology could be associated with a conflict of interest that results in their interest being placed ahead of investors’ interests? Absent the evaluation and identification required under the proposed rule, how would firms form such a reasonable belief? Should we use some other standard, such as a good faith, recklessness, or actual knowledge standard, or some other option? Would such a standard be sufficient to protect investors from the potential harmful impact of conflicts of interest? Is the requirement sufficiently general that it would continue to apply to future technologies with features we may not currently anticipate? If we were to provide additional clarity (whether through guidance or by changing the regulatory text), how should we ensure that the rule’s requirement to identify and evaluate these conflicts is sufficiently general that it would continue to apply to future technologies with features or functionality that we may not currently anticipate? Should we define the terms ‘‘identify’’ or ‘‘evaluate’’ in the regulatory text and, if so, how should they be defined? Should we use different terms to address this concept and, if so, which terms and how should they be defined? 23. The identification and evaluation requirement would also require firms to identify and evaluate conflicts of interest associated with use or potential use of a covered technology by an associated person; what challenges, if E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules any, would firms face due to this aspect of the proposed conflicts rules? Should we make any changes as a result? For example, should we limit the scope of the requirement to conflicts of interest of which the firm is aware or reasonably should be aware or should we limit the scope to any conflict that is reasonably foreseeable? Instead of or in addition to covering conflicts of interest associated with firms’ associated persons’ use of covered technologies, should we prescribe any additional requirements, such as additional diligence or policies and procedures, relating to conflicts of interest associated with firms’ associated persons’ use of covered technologies? The proposed conflicts rules would consider conflicts of associated persons only for associated persons that are individuals, and not of entities that control, are controlled by, or are under common control with a firm, but many of the Commission’s enforcement actions relating to undisclosed conflicts have involved conflicts of firms’ affiliated entities, and not of individuals.152 In addition to natural persons, should we broaden the requirement to cover entities controlling, controlled by, or under common control with firms? 24. Do the proposed conflicts rules provide appropriate clarity around when a firm uses covered technology in an investor interaction? For instance, is the guidance included in this release clear that the proposed conflicts rules would not distinguish between a firm directly using a covered technology in an investor interaction, such as when an investor interfaces with the covered technology without an intermediary of the firm, and when a firm uses covered technology indirectly in an investor interaction, such as where staff of the firm receives the output and communicates it to the investor? Do commenters agree with this scope? Should we instead exclude ‘‘indirect’’ use in investor interactions? Alternatively, should we include indirect uses in investor interactions but apply the rule differently? If so, what safeguards, if any, would be necessary or appropriate for indirect uses in investor interactions? As an example, should the rule make a distinction between an investor interaction using a covered technology itself (e.g., a behavioral feature on a digital platform) and an investor interaction in which the firm uses covered technology indirectly (e.g., a broker emailing a recommendation that it generated using AI-tools)? Should we revise the rule text 152 See, e.g., In re. Charles Schwab & Co, supra note 89. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 to explicitly include ‘‘indirect’’ investor interactions, for example by adding the phrase ‘‘directly or indirectly’’? Alternatively, should the rule text include a definition of ‘‘use’’ within the context of a firm’s use of a covered technology in an investor interaction? 25. How can scalability rapidly exacerbate the magnitude and potential effect of the conflict in a way that could make full and fair disclosure and informed consent unachievable or more difficult? Does this depend on who the investors are (e.g., individuals versus entities)? Is it possible to disclose conflicts that are associated with the use of certain covered technologies in a manner that would enable investors to understand and provide consent? What are the characteristics of such technologies, and how do they differ from PDA-like technologies? How should the final conflicts rules account for such technologies? For instance, should certain uses of covered technologies by firms not be subject to the identification, determination, and elimination or neutralization requirements in the proposed conflicts rules? Should we permit firms to provide disclosure regarding their use of such technologies as an alternative method of complying with the proposed conflicts rules? If so, should the final rules contain principles pursuant to which firms would decide whether and how they are able to disclose the conflicts? Should the Commission instead adopt disclosure standards or criteria? What would those disclosure standards or criteria entail? For example, should one such standard be that the technology is easily understandable to laypersons? What would constitute ‘‘easily understandable to laypersons’’? Alternatively, should the Commission set out different classes of conflicts of interest or different classes of covered technologies and prescribe different ways to address each such conflicts or technologies? 26. Are there particular methods that firms use to identify and evaluate conflicts of interest that we should discuss in the proposed conflicts rules? Should we describe particular methods of identification and evaluation that would comply with the rules? If we were to address such methods specifically, how would we ensure that the rule continues to apply to new technologies and new types of investor interactions as they develop? 27. How widespread is the use of ‘‘black box’’-type models currently? Under existing law, do firms believe that it is possible to use black box technologies in compliance with the applicable standard of conduct and, if PO 00000 Frm 00021 Fmt 4701 Sfmt 4702 53979 so, what steps do they take to comply with the applicable standard of conduct? How will firms using black box technologies meet the requirements of the proposed conflicts rules? Will this require significant changes in firms’ practices? What challenges would firms face when identifying and evaluating conflicts of interest associated with black box technologies, where the outputs do not always make clear which inputs were relied on, and how those inputs were weighted? Are there situations where firms are not able conclusively to identify and evaluate all potential conflicts of interest associated with a covered technology, including because it is a black box? How prevalent are these situations? Will they be able to identify and evaluate whether a firm interest is being considered, or to determine whether such interest is being placed ahead of the interests of investors? Instead of or in addition to the proposed requirements, should we explicitly require that any technologies used by firms be explainable? Is our understanding correct that firms could build ‘‘explainability’’ features into the technology in order to give the model the capacity to explain why it reached a particular outcome, recommendation, or prediction? 28. How will firms conduct conflict of interest identification and evaluation using personnel who are well-trained on both the inner workings of covered technologies used in investor interactions and how to identify common conflicts of interest under the applicable standard of conduct? Are there other methods firms may use, such as third-party consultants and, if so, should we explicitly address these other methods? For example, should we explicitly permit or require a firm to rely on an analysis prepared by a third party identifying and evaluating the conflicts of interest that could be associated with a particular covered technology? If we were to explicitly address third-party analyses, are there particular situations we should address? For example, should we permit firms to rely on analyses by developers of covered technologies that are licensed to firms? What standards would be necessary in order for a firm to reasonably rely on a third-party analysis? For example, should a thirdparty analyst be required to demonstrate a particular level of expertise, possess a particular credential, certification, or license, or be independent from the developer of the technology or the firm relying on the analysis? How should firms address situations where the underlying source code is not available E:\FR\FM\09AUP2.SGM 09AUP2 53980 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules or is incomplete, or where it is very complex? 29. When firms license covered technologies used in investor interactions, is the available documentation sufficient for them to determine whether such technologies present conflicts of interest? Is review of such documentation sufficient for a firm to identify and evaluate conflicts of interest? lotter on DSK11XQN23PROD with PROPOSALS2 b. Testing As part of the identification and evaluation requirement, the proposed conflicts rules would include a requirement to test each covered technology prior to its implementation or material modification, and periodically thereafter, to determine whether the use of such covered technology is associated with a conflict of interest.153 This obligation would help ensure that conflicts of interest that may harm investors are identified in light of how the covered technology actually operates. For example, such testing may surface additional information that would not be apparent simply from reviewing the source code or documentation for the covered technology or the underlying data it uses. It may also surface pre-existing business practices of a firm where the firm considers firm-favorable information in its interactions with investors, and the firm’s use of covered technology that replicates such business practices is associated with a conflict of interest by causing the technology to consider such firm-favorable information. Although the proposed rules would not specify any particular method of testing or frequency of retesting that the firm must conduct, there are two specific times testing is required. A firm would be required to conduct testing prior to the covered technology being implemented.154 A firm also would be required to conduct testing before deploying any ‘‘material modification’’ of the technology, such as a modification to add new functionality like expanding the asset classes covered by the technology. We would not generally view minor modifications, such as standard software updates, security or other patches, bug fixes, or 153 Proposed conflicts rules at (b)(1). Testing would only be required by the proposed conflicts rules as part of the identification and evaluation prong of the rules. As a practical matter, some firms that believe they have eliminated, or neutralized the effect of, conflicts of interest associated with their use of a covered technology may wish to confirm this through testing. See infra section II.A.2.e (describing elimination and neutralization). 154 See infra section II.A.2.e for additional information regarding drift. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 minor performance improvements to be a ‘‘material modification.’’ During the time that the material modifications are being tested, a firm could continue to use an older version of the covered technology if the firm’s use of such previous version of the technology complies with the proposed conflicts rules. The proposed requirement to retest a covered technology periodically does not specify how often retesting would be required. As a result, a firm also would need to determine how often, and the manner in which, to retest covered technologies used in investor interactions.155 As with the proposed identification and evaluation requirement, a firm’s testing methodologies and frequencies may vary depending on the nature and complexity of the covered technologies it deploys. Relatively simple or easy-tounderstand covered technologies where the risk of a conflict of interest is low could be subject to similarly simple testing protocols, and such testing could even take place concurrently with the firm’s efforts to identify and evaluate any conflicts of interest associated with the covered technology. For example, firms that use relatively straightforward technology may determine that it is appropriate to expend the majority of their testing efforts when technology is first implemented (i.e., first deployed) or when it is substantially modified, and any periodic testing may focus only on a sampling of the firm’s covered technologies. On the other hand, firms that use complex covered technologies generally should use testing methodologies and frequencies that are tailored to this complexity and that are based on a review of the particular features that make the technologies more or less likely to involve a conflict of interest. For example, a firm may determine that it is necessary to use specific testing methodologies for certain complex covered technologies. Some covered technologies may need to be tested using A/B testing to determine what factors are being optimized, to determine whether any of those factors are the firm’s interests (or act as proxies for the firm’s interests), or to estimate the effect of the methodology with and without the factors that involve the 155 Though the policies and procedures requirement of the proposed conflicts rules would not explicitly require a firm to specify how often it would retest its covered technologies, as a practical matter, many firms may find it easier to comply with the requirement to retest their covered technologies periodically by implementing a policy to guide firm personnel. PO 00000 Frm 00022 Fmt 4701 Sfmt 4702 firm’s interests.156 Firms may also choose to review data about a technology’s historical performance to monitor signs that it may be optimizing for firm-favorable factors. Likewise, certain learning models are prone to ‘‘drift’’ or ‘‘decay,’’ which can occur when the data the models were trained on differs from the data that they encounter once deployed, and their outputs differ from what would be expected because the training data did not account for such difference. When models are constantly optimized, this can result in a feedback loop that, over time, magnifies small biases and causes the outputs to differ from what would be expected.157 If a model has experienced drift, the drift, on its own, would not constitute a material modification. But if a firm is aware that a model is prone to drift (e.g., due to information developed during the evaluation and identification stage, or through review of the technology’s documentation), the firm would need to take this into account as it complied with other aspects of the proposed conflicts rules in order to help ensure that the steps it took to comply with the proposed rules were effective. A firm that uses covered technologies that exhibit this phenomenon may determine that it is necessary to test the technology more frequently to determine if it continues to function in accordance with the proposed conflict rules, even if the covered technology has not been modified by the firm. The same may be true for covered technologies that function with limited involvement from firm personnel, since otherwise firm personnel may not immediately notice any changes in how the technology functions. As firms consider appropriate timing and manner of retesting, they should consider the nature and complexity of the technology. For example, a firm may determine to test relatively uncomplicated technology or technology used only for interactions that are subject to numerous other compliance controls less frequently than it would test a very complex technology that interacts directly with investors 156 See Seldon, supra note 74. Though the testing requirement is contained in section (b)(1) of the proposed conflicts rules, testing could also be used to aid compliance with other aspects of the proposed conflicts rules. For example, as discussed infra, testing may assist a firm in the determination process in section (b)(2) of the proposed conflicts rules or the elimination and neutralization process in section (b)(3) of the proposed conflicts rules. 157 See AI Infrastructure Alliance, Everything You Need to Know about Drift in Machine Learning (May 25, 2022), https://ai-infrastructure.org/ everything-you-need-to-know-about-drift-inmachine-learning/. E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules without any other human interaction. A firm should also consider whether covered technology continues to be used as intended and as originally tested. For example, if a firm originally develops a technology only for a limited purpose, but then begins to use the technology in additional investor interactions that differ substantially from the original use case, the firm may determine it is necessary to retest the technology with respect to this new use case in order to determine whether any unforeseen conflicts arise as a result. We request comment on all aspects of the proposed conflicts rules’ testing requirement, including the following items: 30. Is the proposed requirement to test covered technologies used in investor interactions prior to implementation sufficiently clear? For example, are there circumstances where it would not be apparent when a technology has been ‘‘implemented’’ for purposes of the proposed conflicts rules? Should we specifically define the term ‘‘implementation,’’ for example by defining it to mean the first time the technology is used in investor interactions? If a firm deploys a covered technology on a ‘‘pilot’’ basis to a limited group of users, should this not be considered to be an ‘‘implementation’’ for purposes of the proposed conflicts rules, even if the technology is used in investor interactions? If we were to provide such an exclusion, what additional safeguards should be required? For example, should firms seeking to rely on this exclusion be required to subject the covered technology to enhanced oversight, such as requiring regular reports on how the technology is being used, requiring members of the pilot group to determine independently whether their use of the technology is resulting in interactions that place the firm’s interests ahead of investors’ interests, or only permitting certain firm personnel to use the technology? Should the exclusion be time-limited, such as a limitation of 30, 60, or 90 days? Who would be eligible to be in the pilot group? Should investors be required to be notified, or to affirmatively consent before interactions with such investors are made part of such a pilot program? Would such a limitation create incentives not to test covered technologies thoroughly enough? 31. Is the proposed requirement to test covered technologies prior to material modification sufficiently clear? For example, are there circumstances where it would not be apparent when a technology has been ‘‘materially modified’’ for purposes of the proposed VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 conflicts rules? We expressed our view that normal-course software updates, bug fixes, and security and other patches are not ‘‘material modifications’’ triggering retesting. Should we require testing of such updates, fixes, and patches? Should we modify the rule text to specify that such updates and patches are not material modifications? Should we provide additional guidance on what constitutes a material modification, such as basing it on ‘‘major’’ version numbers (e.g., 1.XXX, 2.XXX, 3.XXX, etc.) vs. ‘‘minor’’ version numbers (e.g., X.01, X.02, X.03, etc.)? Alternatively, are there situations where reference to version numbers would be inappropriate, such as when a material change for purposes of this rule would be assigned a minor version number? Should we make any special accommodation for technologies that are updated on a regular schedule, regardless of whether such modifications are material? Should firms be required to consider the cumulative impact of several modifications, each of which may not be material on its own, when considering whether a technology has been materially modified? If an algorithm itself has not been modified, but the data considered has been materially modified, should this be treated as a ‘‘material modification’’ for purposes of the proposed conflicts rules? If we were to do so, should we provide additional guidance on how firms should decide when a dataset has been materially modified? 32. Is the proposed requirement to test covered technologies periodically sufficiently clear? Should firms be able to test different covered technologies on different timeframes depending on the specific risks of the covered technologies, as proposed? Should we require that covered technologies at least be tested on an annual basis or other specified frequency? Should we require some or all covered technologies, such as technologies whose outcomes may be difficult to explain or technologies that operate with limited human interaction, to be tested more frequently, such as every 30, 60, or 90 days? 33. Should we specify any particular testing methodologies firms would be required to use, such as A/B testing? If we were to do so, should we only require such methodologies to be used on certain types of technologies and, if so, which ones? For example, should we require only PDA-like technologies (as opposed to all covered technologies) to be tested using certain methodologies such as A/B testing? Are there certain testing methodologies that are only PO 00000 Frm 00023 Fmt 4701 Sfmt 4702 53981 applicable to certain types of technologies? Are there other methods firms may use to test compliance with the proposed conflicts rules, such as third-party consultants and, if so, should we explicitly address these other methods? For example, should we explicitly permit or require a firm to rely on an analysis prepared by a third party? If we were to explicitly address third-party analyses, are there particular situations we should address? For example, should we permit firms to rely on analyses by developers of covered technologies that are licensed to firms? What standards would be necessary in order for a firm to reasonably rely on a third-party analysis? For example, should a third-party analyst be required to demonstrate a particular level of expertise, possess a particular credential, certification, or license, or be independent from the developer of the technology or the firm relying on the analysis? 34. Should we provide an exception from the testing requirement? For example, for urgent changes that are necessary to protect against immediate investor harm, for regulatory reasons, or to correct unexpected developments, such as major bugs, security issues, or conflicts of interest that had not previously been identified (or that developed between periodic testing intervals). Should we require firms to create or maintain any documentation in connection with relying on such an exception? Should reliance on such an exception be subject to any conditions, such as conducting testing as soon as practicable or only for a limited, specified period of time (for example, a few days, a week, or a month)? 35. Should we provide a temporary exception from the testing requirement for technologies that are already in use by firms and, if so, when should that exception expire? If we were to provide a temporary exception for technologies that are already in use, should the temporary exception also apply to other aspects of the proposed conflicts rules, such as the identification and evaluation, determination, or elimination or neutralization prongs, the policies and procedures requirement, or the proposed recordkeeping amendments? c. Conflict of Interest Under the proposed conflicts rules, a conflict of interest would exist when a firm uses a covered technology that takes into consideration an interest of the firm or its associated persons. The proposed conflicts rules would cover use of a covered technology by both a firm and associated persons of the firm E:\FR\FM\09AUP2.SGM 09AUP2 53982 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 and would address technologies that take into account both interests of the firm and the interests of its associated persons.158 The proposed conflicts rules would define ‘‘conflict of interest’’ broadly and make clear that, if a covered technology considers any firm-favorable information in an investor interaction or information favorable to a firm’s associated persons, the firm should evaluate the conflict and determine whether such consideration involves a conflict of interest that places the interest of the firm or its associated persons ahead of investors’ interests and, if so, how to eliminate, or neutralize the effect of, that conflict of interest. We recognize that the proposed conflicts rules—including the broad definition of conflict of interest—means that some conflicts will be identified that do not place the interests of the firm or its associated persons ahead of those of investors, and thus would not need to be eliminated or their effect neutralized. However, a covered technology may consider many factors (e.g., as part of an algorithm or data input). One factor among three under consideration by the technology may be highly likely to cause the technology to place the interests of the firm ahead of investors, and the effect of considering that factor may be readily apparent. On the other hand, one conflicted factor among thousands in the algorithm or data set upon which a technology is based may, or may not, cause the covered technology to produce a result that places the interests of the firm ahead of the interests of investors, and the effect of considering that factor may not be immediately apparent without testing (as discussed above). Without a broad definition and resulting evaluation, this differentiation among factors that do, and do not, result in investor interactions that place the firm’s interests ahead of investors’ interests may be impossible. There are many ways in which a use of covered technology in investor interactions can be associated with a conflict of interest. For example, when covered technology takes into account the profits or revenues of the firm, that would be a conflict of interest under the 158 See paragraph (a) of the proposed conflicts rules. As discussed previously, while the use of covered technology that takes into consideration an interest of the firm or an associated person could present a conflict of interest, the proposed conflicts rules would provide an exception for situations where the covered technology is used in investor interactions solely for purposes of meeting legal or regulatory obligations or providing clerical, ministerial, or general administrative support. See proposed conflicts rules at paragraph (a) and discussion supra section II.A.1.b. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 proposal regardless of whether the firm places its interests ahead of investors’ interests. Revenue or profits can be taken into account directly, such as if a firm populates an asset allocation algorithm on its website to prioritize investments that it is trying to promote because it benefits the firm (e.g., by over-weighting funds that make revenue sharing payments or proprietary funds).159 Likewise, if a firm deploys a covered technology to interact with an investor, such as by displaying selected or ranked options for retirement accounts that takes into account the amount of revenue the firm would receive, the firm’s use of the covered technology would involve a conflict of interest regardless of whether the firm places its interests ahead of investors’ interests. Revenue or profits to the firm can also be indirectly taken into consideration and trigger the proposed conflicts rules, such as through incentivizing increased trading activity or opening of options or margin accounts, if increased trading or opening of such accounts would cause the firm to experience higher profits, such as through increased commissions or revenue sharing from the wholesaler that executes the trade or through increased profits for the firm.160 For example, if a firm uses a neural network to provide investment advice or generate general investment ideas to populate an investment allocation tool, the network may be caused to ingest vast amounts of historical or real-time data, then repeatedly be optimized or trained to determine which outcome(s) to generate.161 If one of the pieces of data that the neural network considers is the effect on the firm’s interests, such as the firm’s profitability or revenue, it involves a conflict that should be examined to determine whether it could produce outcomes, including changing outcomes over time (e.g., through drift), 159 A conflict could exist irrespective of whether investment in such funds is in the best interest of the investor. 160 These conflicts are distinct from the limited exception for conflicts of interest associated with more generally attracting investors to open new accounts, discussed in section II.A.2.e, infra, because generally attracting new investors is essential to the business of any firm. On the other hand, incentivizing specific types of activity (such as margin or options trading privileges, as opposed to opening a general account, or investing in a particular type of investment, as opposed to just opening an account to invest) that is particularly profitable to a firm (and is not always in investors’ interest), is intentionally addressed by the proposed conflicts rules. 161 See, e.g., Alexey Dosovitskiy, Google Research, Optimizing Multiple Loss Functions with LossConditional Training (Apr. 27, 2020), https:// ai.googleblog.com/2020/04/optimizing-multipleloss-functions-with.html. PO 00000 Frm 00024 Fmt 4701 Sfmt 4702 that place the interest of the firm ahead of the interest of the investor. The specific interest that is taken into account, and the degree to which it is weighted in the covered technology, would not affect the determination of whether a conflict of interest exists, as the presence of any firm interest in any degree, for the reasons discussed above, would constitute a conflict of interest. Such considerations would be relevant, however, when considering whether the conflict of interest places the interest of the firm ahead of those of investors and therefore whether it is necessary to eliminate, or neutralize the effect of, the conflict of interest, as discussed further below, and, if so, what steps could be taken to do so.162 We request comment on all aspects of the proposed definition of conflict of interest, including the following items: 36. Do commenters agree that a firm would have a conflict of interest with an investor if the firm takes into consideration its profits and revenues in its investor interactions using covered technology? Why or why not? Are there additional circumstances that should trigger the rule if the firm takes these circumstances into account in its investor interactions, such as considering any factor which is not directly in the interest of the investor? Should we narrow the proposed definition and, if so, are there particular activities that should be excluded, such as when a technology considers a very large dataset where the firm has no reason to believe that the data considers the interests of the firm, like a technology trained on all books in the English language? Are there other datasets that should be excluded and, if so, how broad should a dataset be required to be in order to qualify for the exclusion? If we were to provide an exclusion, should we do so by excluding particular activities or types of datasets by name, or through a more principles-based approach? 37. Is the description of when a conflict of interest exists sufficiently clear? Would firms be able to identify what would and would not be a conflict of interest for purposes of the rules? Advisers already have a fiduciary duty to eliminate, or at least to expose, all conflicts of interest which might incline them—consciously or unconsciously— to render advice that is not disinterested, and broker-dealers already have a duty to identify and at a minimum disclose or eliminate all conflicts of interest associated with a recommendation and mitigate certain conflicts of interest under Reg BI. How 162 See E:\FR\FM\09AUP2.SGM infra section II.A.2.e. 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules do firms currently identify conflicts of interest associated with their use of what the proposed conflicts rules would define as covered technologies in order to ensure that such use complies with existing standards? Will it be confusing to firms that the proposed conflicts rules also use the term ‘‘conflict of interest’’ to describe a distinct, but related, concept? If so, should we use a different term other than ‘‘conflict of interest,’’ such as a ‘‘technology conflict’’ or a ‘‘potential conflict of interest?’’ 38. The proposed definition of ‘‘conflict of interest’’ would also include interests of firms’ associated persons. What challenges, if any, would firms face due to this aspect of the proposed conflicts rules? Should we make any changes as a result? For example, should we limit the scope of the definition to conflicts of interest of which the firm is aware or reasonably should be aware? Instead of or in addition to covering conflicts of interest that arise due to the interests of firms’ associated persons, should we prescribe any additional requirements, such as additional diligence or policies and procedures, relating to conflicts of interest of firms’ associated persons? In addition to natural persons, should we explicitly adopt a definition of ‘‘conflict of interest’’ that would cover interests of entities controlling, controlled by, or under common control with firms, or other affiliates (or modify the rule provisions requiring the consideration of conflicts of associated persons to remove the limitations to associated persons that are natural persons)? 39. If we were to provide an exclusion for technologies that consider large datasets where firms have no reason to believe the dataset favors the interests of the firm, should we require such datasets to meet minimum standards? For example, should we require firms to conduct diligence regarding how the data was collected in order to support their determination that the dataset does not incorporate the firm’s interests? Should there be different standards for data that is itself generated in part by a technology that may meet the definition of covered technology (and thus may incorporate its own conflicts of interest), such as subjecting that technology to all or part of the proposed rules? 40. Should we incorporate other minimum standards into data considered by covered technologies that are not directly related to interests of the firm but may implicate other Commission priorities, or have public policy implications? For example, should we require firms to take steps to understand whether the data does or could involve material nonpublic VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 information? Should firms be required to consider whether the data is sensitive data that could be subject to cybersecurity or privacy rules? 41. Do firms ever provide firmfavorable information to their covered technologies for the purpose of explicitly instructing the covered technology not to consider such information? Are there other circumstances in which covered technologies consider firm-favorable information that do not raise conflict of interest concerns? If so, should we make any changes to the definition of conflict of interest as a result? How could firms determine that no conflict of interest concerns are associated with their use of a covered technology without conducting the steps that would be required under the proposed conflicts rules? 42. Is it clear that the proposed definition of conflict of interest includes when the covered technology has the potential to take into account the firm’s (or its associated persons’) interests, including the firm’s revenue or profits, directly or indirectly? Are there steps we could take to clarify, for example by providing additional examples of factors that, if considered, would constitute a conflict of interest? 43. Do commenters agree that, as proposed, a conflict of interest would exist even if a covered technology factors in a single firm- or associated person-favorable interest among many other factors that do not favor the firm or its associated person, regardless of which interest is favored and the degree to which it is weighted? Should the specific interest of the firm or associated person that is taken into account, such as the firm’s revenues or profits, or the degree to which it is weighted in the covered technology, affect the determination of whether a conflict of interest exists at all? How would this differ in practice from determining that a conflict of interest does exist but does not place the firm’s interests ahead of investors’ interests? 44. Should we exclude certain categories of conflicts? d. Determination The proposed conflicts rules would require a firm, after evaluating any use or reasonably foreseeable potential use of a covered technology by a firm or its associated person in any investor interaction to identify any conflict of interest associated with that use or potential use, to determine whether such conflict of interest places or results in placing the firm’s or its associated person’s interest ahead of investors’ interests, subject to certain PO 00000 Frm 00025 Fmt 4701 Sfmt 4702 53983 exceptions.163 Determining whether an investor interaction involving such a conflict of interest would place or results in placing the firm’s or its associated person’s interests ahead of investors’ interests is a facts and circumstances analysis, and would depend on a consideration of a variety of factors, such as the covered technology, its anticipated use, the conflicts of interest involved, the methodologies used and outcomes generated, and the interests of the investor. Based on this analysis, a firm must reasonably believe that the covered technology either does not place the interests of the firm or its associated persons ahead of investors’ interests, or the firm would need to take additional steps to eliminate, or neutralize the effect of, the conflict.164 Applicable law already limits firms’ use of technologies whose outputs are based in part on data points favorable to a firm in certain circumstances. Investment advisers using such technologies to provide investment advice are already required to consider whether they could cause the adviser ‘‘consciously or unconsciously to render advice which is not disinterested.’’ 165 Similarly, brokerdealers that use technology to make certain recommendations to a retail customer must establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI, including its Conflict of Interest Obligation.166 In the case of many covered technologies, it may be readily apparent that, while the technology may take into account an interest of the firm, it does not result in the firm’s interests being placed ahead of investors’ interests. For example, many investment advisers create financial models of a portfolio company’s three financial statements (i.e., the company’s balance sheet, income statement, and statement of cashflows) to help evaluate whether to advise their clients to invest in a particular portfolio company. It is not uncommon for a financial model to show the potential returns of the investment for the client, along with a potential performance-based fee that would be received by the adviser, if the portfolio company achieved certain levels of growth. An adviser’s consideration of metrics that are favorable to it, such as a potential 163 Proposed conflicts rules at (b)(2). proposed conflicts rules do not prescribe strict numerical weights. Instead, determination of the relative level of benefits to the firm and to the investor should take into account all applicable facts and circumstances. 165 See Fiduciary Interpretation, supra note 8. 166 See Exchange Act rule 15–1(a)(2)(iii) and (iv). 164 The E:\FR\FM\09AUP2.SGM 09AUP2 53984 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 performance-based fee it could receive, would constitute a conflict of interest under the proposed conflicts rules. Under the determination requirement, however, the adviser could, based on the applicable facts and circumstances, determine that such conflict of interest does not result in its own interests being placed ahead of investors’ interests if the outcome is equally (or more) favorable to the investor regardless of whether the factor is considered.167 On the other hand, if the model is designed to screen out an investment if it would not result in a sufficient performance-based fee for the adviser despite acceptable returns for investors, this would be an example of the adviser’s interests being placed ahead of investors’ interests because the investors are being deprived of an investment due to the adviser’s consideration of its own interest. Covered technologies like the model in this example, which explicitly and intentionally consider a firm’s interests as an integral part of its outputs, are highly likely to result in investor interactions that place the interests of the firm ahead of investors’ interests. Firms should consider carefully reviewing the outputs of such technologies to determine whether the firm’s or its associated persons’ interests are being placed ahead of the interests of the investor (e.g., by reviewing how the outputs vary if the firm’s or associated persons’ interests are not considered). Similarly, a broker-dealer may bring general investment ideas to the attention of retail investors, using an algorithm for selection, where some of the investments that may be selected provide revenue to the firm if the investor places an order to purchase. If the firm determines that in selecting the investment ideas, the algorithm used for selecting the investment ideas does not place the firm’s interests ahead of investors’ interests—because, for example, it does not give more prominence to the investments that provide revenue to the firm than those that do not and no one investment is 167 Even though the proposed conflicts rules would not require the conflict of interest to be eliminated or its effect to be neutralized, this would remain a conflict of interest under the proposed conflicts rules (and under existing law). See Performance-Based Investment Advisory Fees, Investment Advisers Act Release No. 5904 (Nov. 4, 2021) [86 FR 62473 (Nov. 10, 2021)], at n.3 and accompanying text (noting the incentive ‘‘to engage in speculative trading practices while managing client funds in order to realize or increase [contingent] advisory fees’’ such as incentive allocations). An adviser would still be required to disclose the conflict with sufficient specificity that a client could provide informed consent. See Fiduciary Interpretation, supra note 8, at nn.67–70 and accompanying text. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 being recommended—it could reasonably determine that the conflict of interest created by the algorithm considering the revenue does not require elimination or neutralization under the proposed conflicts rules.168 If, on the other hand, the firm determined that the algorithm was more likely to give greater prominence to those investments that are more profitable for the firm over other options of equal or better quality, then it could not reasonably determine that the conflict does not result in investor interactions that place its interests ahead of investors’ interest and thus, would be required to eliminate, or neutralize the effect of, the conflict by the proposed conflicts rules. As another example, the covered technology a firm uses to decide when to communicate with investors may send an automatic message to investors encouraging them to ‘‘hold steady’’ during a period of high volatility in the market. If the technology is programmed to send out such a message during a period of high volatility but only after a certain threshold of fee-earning assets are withdrawn from the firm, the use of that technology would involve a conflict of interest because it would consider a proxy for the firm’s revenues. However, if the primary purpose of the automatic message is to keep investors from overreacting to short-term market moves, that could be beneficial for such investors. Even though the firm would be required to identify and evaluate the conflict of interest in order to comply with the proposed conflicts rules, the firm could reasonably determine that its interests were not placed ahead of investors’ interests, and thus it did not need to eliminate, or neutralize the effect of, the conflict of interest. A firm generally should tailor the methods by which it determines whether its use of covered technologies in investor interactions places its interests ahead of investors based on the circumstances and the complexity of the underlying covered technology as well as the complexity of the conflict of interest. To the extent a firm has difficulty identifying whether a use of a covered technology in an investor interaction presents a conflict of interest within the meaning of the proposed conflicts rules, it also would have difficulty determining whether the technology could place the interests of the firm ahead of the interests of 168 While the proposed conflicts rules may not require elimination or neutralization, to the extent a broker-dealer uses such technology to make a recommendation to a retail customer, other existing regulatory obligations, such as Reg BI and Form CRS, would apply. See supra section I.B. PO 00000 Frm 00026 Fmt 4701 Sfmt 4702 investors.169 In such circumstances, the firm may need to use additional tools to comply with the proposed determination requirement. For example, if a firm built ‘‘explainability’’ functionality into the covered technology that gives the model the capacity to explain why it reached a particular outcome, recommendation, or prediction, this functionality could assist with the identification and determination elements of the proposed conflicts rules.170 A firm using explainability features could review the output to determine whether the firm’s interests were being placed ahead of those of investors and, in any circumstance where it was not clear whether the firm’s interests were being placed ahead of investors, the firm could comply with the proposed conflicts rules for example, by ceasing to use the technology or by prophylactically treating such an ambiguity as a conflict of interest that must be eliminated or its effect neutralized.171 Even when explainability features are built into a covered technology, a firm might still be unable to determine whether the covered technology places its own interests ahead of investors’ interests. If a firm cannot determine that its use of a covered technology in investor interactions does not result in a conflict of interest that places its interests ahead of those of investors, the firm generally should consider any conflict of interest associated with such use as one that must be eliminated or its effect neutralized, and take steps necessary to do so.172 For example, as 169 See supra note 151 and surrounding text (discussing building explainability features into ‘‘black box’’ algorithms). We believe that the ‘‘should have identified’’ standard in paragraph (b)(3) of the proposed conflicts rules addresses situations where a firm’s determination that a conflict of interest does not place its interests ahead of investors’ turns out to be unreasonable because it would still hold a firm accountable for the unreasonable determination. See infra section II.A.2.e. 170 See id. 171 See infra section II.A.2.e. 172 See infra section II.A.2.e (discussing the ‘‘should have’’ identified standard). Firms that are unable to determine whether their own interests are placed ahead of investors’ for purposes of the proposed conflicts rules should consider whether full and fair disclosure to facilitate informed consent are feasible in such circumstances. See, e.g., infra note 316 and accompanying text (discussing informed consent in the context of highly complex algorithms). In such circumstances, when informed consent is impossible, existing law requires an investment adviser to mitigate the conflict, which could include steps similar to those we outline in the discussion of elimination and neutralization. Similarly, where a broker-dealer that makes a recommendation to a retail customer using covered technology cannot provide ‘‘full and fair’’ disclosure of a conflict of interest, the broker-dealer E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 explained more fully in the following section, the firm could apply a ‘‘counterweight’’ to a conflict (that is, it could give more weight to certain investor-favorable information in order to make up for the consideration of firmfavorable information) that would be sufficient to neutralize the effect of conflicts that the firm reasonably foresees could result from the use of the covered technology.173 We acknowledge determinations for covered technologies that consider a multitude of different data points may render it more challenging to isolate the effect of any particular data point on the outcome and, thus, to determine whether it causes a conflict of interest that places the interest of the firm ahead of investors. These cases, in particular, may benefit from the testing methods outlined above. For example, A/B testing may reveal that there is no difference in outcomes in cases where the covered technology includes or excludes certain data points or groups of data points. We request comment on all aspects of the proposed conflict rules’ determination requirement, including the following items: 45. Does the proposed conflicts rules’ determination requirement complement, overlap with, or duplicate the existing regulatory framework for broker-dealers and investment advisers? If so, in what ways? Specifically, would firms’ compliance with those other regulatory requirements contribute to compliance with the proposed conflicts rules, and vice versa? 46. Is the proposed requirement that a firm determine whether any conflict of interest that it has identified places or results in placing its or its associated persons’ interests ahead of investors’ interests sufficiently clear? Is the requirement sufficiently general that it would continue to apply to future technologies with features we may not currently anticipate? If not, why not? Do commenters agree that a conflict of interest that places a firm’s or its associated persons’ interests ahead of investors’ interests also results in placing its or its associated persons’ may need to take additional steps to mitigate or eliminate the conflict under the existing standard of conduct. See Reg BI Adopting Release, supra note 8, at section I and text accompanying nn.735– 36 (‘‘[B]roker-dealers are most capable of identifying and addressing the conflicts that may affect the obligations of their associated persons with respect to the recommendations they make, and are therefore in the best position, to affirmatively reduce the potential effect of these conflicts of interest such that they do not taint the recommendation.’’). 173 This is due to the ‘‘should have identified’’ standard. See infra section II.A.2.e. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 interests ahead of investors’ interests? If so, is the rule clearer by including both phrases or should the proposed requirement eliminate the phrase ‘‘results in placing’’? 47. How do firms currently determine whether their use of technology in investor interactions results in a conflict of interest that places the interests of the firm ahead of investors’ interests? Are there particular processes or strategies that should be required in the proposed determination requirement? For example, should we specifically require the use of ‘‘explainability’’ features when the relationship between the outputs of a model and the inputs may be unclear (and it thus may be difficult to identify whether the interests of the firm are being placed ahead of investors’ interests)? Do firms use A/B testing to determine the effects of conflicts of interest? What other types of testing do firms use to determine the effects of conflicts of interest, if any? 48. What challenges will firms face when determining whether conflicts of interest associated with ‘‘black box’’ technologies (where the outputs do not always make clear which inputs were relied on, and how those inputs were weighted), result in their interests being placed ahead of those of investors? How prevalent are these situations? How do firms using ‘‘black box’’ technologies to aid in making recommendations or providing advice determine whether they are complying with existing conflicts obligations under the investment adviser fiduciary standard and Reg BI, as applicable? If a firm is not able to determine whether its use of such a technology results in a conflict of interest that places its interests ahead of those of investors, what additional steps will a firm need to take in order to eliminate, or neutralize the effect of, such conflicts and be able to continue to use the covered technology? 49. The determination requirement would also require firms to determine whether the interests of an associated person of a firm are placed ahead of investors’ interest. What challenges, if any, would firms face due to this aspect of the proposed conflicts rules? Should we make any changes as a result? For example, should we limit the scope of the requirement to conflicts of interest of which the firm is aware or reasonably should be aware? Instead of or in addition to covering firms’ associated persons’ interests, should we prescribe any additional requirements, such as additional diligence or policies and procedures, relating to conflicts of interest associated with firms’ associated persons? In addition to natural persons, should the PO 00000 Frm 00027 Fmt 4701 Sfmt 4702 53985 determination requirement apply in the context of entities that control, are controlled by, or are under common control with firms? 50. Should we expand the determination requirement to cover other situations that would not be a ‘‘conflict of interest’’ as defined under the proposed conflicts rules, but would implicate other Federal securities laws, or other laws? For example, should firms be required to identify and evaluate whether their covered technologies use or consider any information that could be material nonpublic information? 51. Are there other methods firms may use to determine whether a conflict of interest results in placing the interest of the firm or an associated person of the firm ahead of the investor, such as third-party consultants and, if so, should we explicitly address these other methods? For example, should we explicitly permit or require a firm to rely on an analysis prepared by a third party? If we were to explicitly address third-party analyses, are there particular situations we should address? For example, should we permit firms to rely on analysis by developers of covered technologies that are licensed to firms? What standards would be necessary in order for a firm to reasonably rely on a third-party analysis? For example, should a third-party analyst be required to demonstrate a particular level of expertise, possess a particular certification or license, or be independent from the developer of the technology or the firm relying on the analysis? e. Elimination or Neutralization of Effect The proposed conflicts rules would require a firm to eliminate, or neutralize the effect of, any conflict of interest it determines results in an investor interaction that places the firm’s (or its associated persons’) interest ahead of the interests of its investors.174 Consideration of any firm interest would be sufficient for a conflict of interest to exist under the proposed conflicts rules, but the consideration of a firm’s interest, on its own, would not necessarily require that the firm eliminate, or neutralize the effect of, the conflict of interest.175 After identifying that a conflict of interest exists, the firm would then determine whether the conflict of interest results in the interest of the firm or an associated person being placed ahead of investors’ interests. Only where the firm makes (or reasonably should make) such a 174 Proposed 175 See E:\FR\FM\09AUP2.SGM conflicts rules at (b)(3). infra section II.A.2.d. 09AUP2 53986 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 determination would the firm be required to eliminate, or neutralize the effect of, the conflict of interest.176 The proposed conflicts rules would require the firm to eliminate, or neutralize the effect of, any such conflict promptly after the firm determines, or reasonably should have determined, the conflict placed the interests of the firm or associated person ahead of the interests of investors. This requirement is designed to require a firm to take steps that are in addition to, but not in conflict with, the standard of conduct that applies when it is providing advice or making recommendations, as discussed below.177 The test for whether a firm has successfully eliminated or neutralized the effect of a conflict of interest is whether the interaction no longer places the interests of the firm ahead of the interests of investors.178 Under the proposed conflicts rules, a firm could ‘‘eliminate’’ a conflict of interest, for example, by completely eliminating the practice (whether through changes to the algorithm, technology, or otherwise) that results in a conflict of interest or removing the firm’s interest from the information considered by the covered technology. For example, a firm that determined covered technology used in investor interactions favored investments where its receipt of revenue sharing payments placed the firm’s interests ahead of investors’ interests could eliminate the conflict, among other methods, by ending revenue sharing arrangements or by ensuring that its covered technologies do not consider investments that pay it revenue sharing payments. However, a firm does not have to eliminate such conflicts. A firm instead could ‘‘neutralize the effect of’’ a conflict of interest by taking steps to address the conflict. In this regard, whether through elimination or neutralization, the proposed conflicts rules would require that any conflicts of interest not place the firm’s interest ahead of investors’ interests. In a neutralization scenario, the covered 176 For the avoidance of doubt, the discussion concerns consideration by a technology of the interests of a firm, including situations where the firm creates technology that considers the firm’s or an associated person’s interests. Firms of course will consider their own interests (such as whether the cost of the technology is worth the benefit) when determining whether to deploy a technology. Such consideration, on its own, would not be within the scope of the proposed conflicts rules. 177 See infra section III.C.3. (describing the applicable standards of conduct). 178 For the avoidance of doubt, if a firm substitutes one firm-favorable factor with a different factor that is a proxy for the firm-favorable factor, the firm has not eliminated, or neutralized the effect of, the conflict. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 technology could continue to use the data or algorithm that includes the firm’s or associated person’s interest as a factor, but the firm would be required to take steps to prevent it from biasing the output towards the interest of the firm or its associated persons. The measure of whether the effect of the conflict has been neutralized would be if the investor interaction does not place the firm’s or associated person’s interest ahead of the investor. We are including neutralization as an additional method of addressing conflicts of interest under the proposed conflicts rules because of the unique ways that technology can be modified or counterweighted to eliminate the harmful effects of a conflict, as well as the ways it can be tested to confirm the modification or counterweighting was successful. Neutralization, for example, also could include rendering the consideration of the firm-favorable information subordinate to investors’ interests, and thus making the conflict harmless, either by applying a ‘‘counterweight’’ (such as considering additional investor-favorable information that would not have otherwise have been considered in order to counteract consideration of a firmfavorable factor) or by changing how the information is analyzed or weighted such that the technology always holistically weights other factors as more important so that biased data cannot affect the outcome. The proposed conflicts rules do not prescribe a specific way in which a firm must eliminate, or neutralize the effect of, its conflicts of interest. For example, if a firm that is a robo-adviser determines that it uses covered technology to direct or steer investors to invest in funds the firm itself sponsors and advises when more suitable or less expensive options for the investor are available through the robo-adviser, and thereby prioritizes the firm’s own profit over investors’ interests, the firm could eliminate this conflict of interest by removing any data that would allow the robo-adviser to determine which funds are sponsored or advised by the firm, thus eliminating any bias in favor of the firm’s interest.179 The firm, alternatively, may choose to neutralize the effect of the conflict.180 For instance, 179 As discussed supra section II.A.1.b, this includes a discretionary adviser where the investor does not need to approve each trade; the investor interaction in this case would be in the form of engagement through directing trades in the investor’s account. 180 As discussed above, this is also consistent with an adviser’s fiduciary duty. An adviser ‘‘must, at all times, serve the best interest of its client and not subordinate its client’s interest to its own’’ and, PO 00000 Frm 00028 Fmt 4701 Sfmt 4702 the firm could neutralize the effect of the conflict of interest by sufficiently increasing the weights given to factors, such as cost to the investor or riskadjusted returns (including, in each case, comparisons to funds sponsored or advised by other firms), to provide a counterweight that prevents any consideration of the firm’s own interests from resulting in an investor interaction that places the firm’s interests ahead of investors’ interests. The proposed conflicts rules permit firms discretion on how to address the conflict—whether by eliminating it altogether or neutralizing its effect—after considering the applicable facts and circumstances, provided that the method used prevents the firm from placing its interests or an associated person’s ahead of investors’ interest. The proposed conflicts rules do not prescribe a particular manner by which a firm must eliminate, or neutralize the effect of, any conflict of interest because of the breadth and variations of firms’ business models as well as their use of covered technology. Because of the complexity of many covered technologies, as well as the ways in which conflicts of interest may be associated with their use, we are concerned that prescribing particular means to neutralize the effect of a conflict of interest could be inapplicable or otherwise ineffective with respect to certain covered technologies (or certain conflicts of interest, the nature and extent of which may vary substantially across firms depending on their particular business models and investor base).181 The proposed approach is intended to promote flexibility and innovation by allowing the firms that use covered technologies the freedom to determine the appropriate ways to operate them, within the guardrails provided by the proposed conflicts rules, rather than requiring the technologies to be designed in a unless neutralized, a conflict of interest would have the effect of subordinating a client’s interest to that of the firm. See Fiduciary Interpretation, supra note 8. Similarly, under Reg BI, broker-dealers must mitigate (i.e., reduce) or eliminate conflicts of interest that would otherwise cause the brokerdealer or its associated person to make a recommendation that is not in the best interest of the retail customer. See Exchange Act rule 15l– 1(a)(2)(iii); Reg BI Adopting Release, supra note 8, at section II.C.3.g (‘‘Elimination of Certain Conflicts of Interest’’). 181 This same recognition of the complexity of many covered technologies is why disclosure alone could be insufficient to adequately address the conflicts of interest associated with their use. Cf. infra section III.D.1 (disclosure alone may not necessarily address negative outcomes when ‘‘the issue lies in human psychological factors, rather than a lack of information.’’). E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 particular way solely to meet a regulatory requirement. We recognize that reasonable steps a firm could take to eliminate, or neutralize the effect of, a conflict of interest that results in an investor interaction that places the firm’s interest ahead of investors, are likely to vary and would depend on the nature of the conflict, the nature of the covered technology, the circumstances in which the covered technology is used, and the potential harm to investors. For example, if the firm’s evaluation of the conflict indicates that the technology would only result in investor interactions that place the firm’s or an associated person’s interests ahead of investors’ interests in certain limited circumstances, a firm could eliminate the conflict of interest by taking steps to prevent the technology from being used in such circumstances, or by choosing to eliminate the business practice that is associated with the conflict in the first place. Similarly, if a technology only involves a conflict of interest due to its consideration of certain data or the weights ascribed to certain data points, the firm could either prevent the technology from accessing such data (eliminating the conflict), or the firm could take steps to prevent its consideration of the data from having an effect on the outcome of the technology (neutralizing the effect of the conflict), either through consideration of additional, investor-favorable data designed to provide a countervailing signal to the technology, or through weighting the data the covered technology considers so that the firm- or associated person-favorable data would not be determinative to the outputs.182 A firm could also neutralize the effect of a conflict by requiring that firm personnel who are trained on the nature of the conflict of interest (e.g., personnel responsible for supervising the implementation of the firm’s compliance program) operate the technology and only pass along information to investors after they deem, based on their training, that the information does not involve a conflict that results in an investor interaction that places the interests of the firm or an associated person ahead of investors’ interests.183 182 Whether the firm-favorable data is determinative of the technology’s outputs could be verified through A/B testing. See supra section II.A.2.b. The specific data or weights that would be necessary to neutralize a particular conflict would depend on factors such as the conflict itself as well as the design of the applicable technology. 183 This example assumes the investor interaction is indirect; we anticipate that firm personnel would not have the ability to intervene when a technology directly interacts with investors. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 The proposed conflicts rules would require a firm to eliminate, or neutralize the effect of, a conflict of interest that it determines results in an investor interaction that places its interests ahead of investors’ interests ‘‘promptly’’ after the firm determines, or reasonably should have determined, that the conflict results in its own (or an associated person’s) interests being placed ahead of investors’ interests.184 Determining what constitutes ‘‘promptly’’ in any given situation under the proposed conflicts rules would depend on the facts and circumstances. If eliminating, or neutralizing, the effect of, the conflict is straightforward, as would be the case if a firm simply had to update the settings of an application or restrict access using tools it already possessed, elimination or neutralization could happen soon after the identification of the conflict of interest. But if elimination, or neutralization of the effect of, a conflict of interest would require substantial amounts of new coding by firm personnel, we recognize that such modifications may take longer to implement, including because they may constitute material modifications that would need to be tested to determine whether any modifications eliminated, or neutralized the effect of, the conflict as expected, as well as to consider any new conflicts of interest that the modifications could cause. Though we recognize that modifications would not happen immediately in all circumstances, an extended period of implementation may raise questions about whether the firm acted promptly and may raise questions as to whether they are acting in accordance with their standard of care. If a firm has determined that it needs additional time to eliminate, or neutralize the effect of, a conflict of interest in accordance with the proposed conflicts rules, it would also need to consider whether continuing to use such covered technology before the conflict is eliminated or neutralized would violate any applicable standard of conduct (e.g., fiduciary duty for investment advisers or Reg BI for broker-dealers). In certain cases, it may be impossible to comply 184 If it is determined before technology is first deployed that a conflict of interest exists that places the firm’s or an associated person’s interests ahead of investors’ interests, ‘‘prompt’’ elimination or neutralization of the conflict could occur any time before the technology is initially deployed. That is, we do not believe it would be consistent with the proposed conflicts rules for a firm to initially deploy a technology that a firm has already determined (or should have determined) is subject to conflicts of interest that place the firm’s or an associated person’s interests ahead of its investors’ interests, then eliminate, or neutralize the effect of, those conflicts after the fact. PO 00000 Frm 00029 Fmt 4701 Sfmt 4702 53987 with the applicable standard of conduct without stopping use of the covered technology before the conflict of interest can be adequately addressed. As it develops a schedule for eliminating, or neutralizing the effect of, the conflict, a firm should consider the nature of the covered technology, including how it is being used in investor interactions, and the complexity of any elimination or neutralization measures. The firm should also consider and seek to minimize potential risks posed to investors as a result of the continued use of the covered technology. This might include implementing heightened review of investor interactions to help ensure that the harm is relatively limited and weighing the risks of continued exposure to the conflict of interest during remediation against the risk of making the covered technology unavailable during remediation. If a firm has a reasonable basis to believe that pulling a covered technology out of service due to a conflict of interest would be a greater risk to investors than the conflict itself, a firm generally should consider closely surveilling and monitoring the investor interactions associated with its continued use of the technology to evaluate whether its expectation is accurate, or whether it should cease using the covered technology. The requirement for a firm to eliminate, or neutralize the effect of, conflicts of interest that place the firm’s or an associated person’s interest ahead of investors’ interests covers such conflicts the firm identifies, as well as those it reasonably should have identified. That is, in order to comply with the proposed conflicts rules, a firm would be required to use reasonable care to determine whether these conflicts could arise as a result of its use of covered technologies and how they could affect investor interactions, and to address such conflicts rather than assuming that its covered technologies do not result in its own (or its associated persons’) interests being placed ahead of investors’ interests. The ‘‘reasonably should have identified’’ standard is designed to require firms to understand the covered technology they are deploying sufficiently well to consider all the material features of the technology both when evaluating the technology and identifying conflicts, and later when determining whether those conflicts place their own (or their associated persons’) interests ahead of investors’ interests. Because firms’ use of covered technology is likely to be continuously changing, firms generally should consider how they will proactively E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 53988 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules address reasonably foreseeable uses (which would include potential misuses) of the covered technology. Firms should identify future and evolving conflicts when evaluating their potential use of covered technology to make sure that they have eliminated, or neutralized the effect of, all conflicts they should have determined place their interests ahead of investors’ interests, including as their use of technology evolves. One way to address potential misuses of a technology could be to limit access to particular technology to personnel who have been trained on the technology and how to use it in compliance with the proposed conflicts rules. This could prevent the technology from being used in investor interactions that place the firm’s interests ahead of investors’ interests. The proposed requirement is also designed to be consistent with a firm’s applicable standard of conduct. Investment advisers, as fiduciaries, are prohibited from subordinating their clients’ interests to their own (i.e., they may not place their interests ahead of their clients’ interests).185 In addition, investment advisers must eliminate or at least expose through full and fair disclosure all conflicts of interest which might incline an investment adviser— consciously or unconsciously—to render advice which was not disinterested.186 Where an adviser uses covered technology in an investor interaction, compliance with the proposed conflicts rules’ requirement that conflicts of interest be eliminated or their effect neutralized could also help the adviser satisfy its fiduciary duty. Likewise, in satisfying its fiduciary duty, an adviser may also satisfy the proposed conflicts rules’ requirement to eliminate, or neutralize the effect of, certain conflicts of interest. However, due to our concerns that scalability could rapidly exacerbate the magnitude and potential effect of conflicts,187 an adviser would not satisfy the proposed conflicts rules’ requirement to eliminate, or neutralize the effect of, certain conflicts solely by providing disclosure to investors. As the Commission has previously stated, in cases where an investment adviser cannot fully and fairly disclose a conflict of interest to a client such that the client can provide informed consent, the adviser must take other steps such that full and fair disclosure and 185 See Fiduciary Interpretation, supra note 8, at section II. 186 See Fiduciary Interpretation, supra note 8, at n.57 and accompanying text. 187 See supra section I.A. for a discussion about scalability concerns. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 informed consent to the adviser’s other business practices are possible.188 Moreover, as the Commission has previously stated, investment advisers must act in the best interests of their clients at all times and must not subordinate their clients’ interests to their own.189 The standard in the proposed conflicts rules is thus consistent with that over-arching fiduciary obligation. Similarly, when making recommendations, broker-dealers must act in the best interest of a retail customer at the time the recommendation is made, without placing the firm’s financial or other interest ahead of the retail customer’s interests. This would include, under Reg BI’s Conflict of Interest Obligation, a requirement to establish, maintain, and enforce written policies and procedures reasonably designed to, among other things, identify and at a minimum disclose, or eliminate, all conflicts of interest associated with a recommendation; identify and mitigate (i.e., modify practices to reduce) conflicts of interest at the associated person level; prevent any limitations placed on the securities or investment strategies involving securities that may be recommended to a retail customer and associated conflicts of interest from causing the broker-dealer, or a natural person who is an associated person of the broker-dealer, to make recommendations that place the interest of the broker-dealer or such natural person ahead of the interest of the retail customer; and eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.190 Accordingly, where a broker-dealer uses covered technology to make a recommendation, compliance with the proposed conflicts rules’ requirement that conflicts of interest be eliminated or their effect neutralized could also help a broker-dealer comply with similar aspects of Reg BI’s Conflict of Interest Obligation. For example, if a broker-dealer uses covered technology to make a recommendation to a retail customer, and the broker-dealer eliminates, or neutralizes the effect of, any firm- and associated person-level conflicts of interest under the proposed conflicts rule, it could help address compliance with certain aspects of Reg BI’s Conflict of Interest Obligation. Conversely, 188 See Fiduciary Interpretation, supra note 8, at text following n.67. 189 See generally id. 190 See Exchange Act rule 151–1(a)(2)(iii). PO 00000 Frm 00030 Fmt 4701 Sfmt 4702 compliance with Reg BI’s Conflict of Interest Obligation could help a brokerdealer comply with the proposed conflicts rules’ requirement to eliminate, or neutralize the effect of, certain conflicts of interest. However, because the proposed conflicts rules apply more broadly to the use of covered technology in investor interactions as noted earlier,191 and not just to recommendations, broker-dealers would be subject to both the proposed conflicts rules’ requirements and, separately when making a recommendation, Reg BI, depending on the facts and circumstances of the investor interaction and the use of the covered technology.192 Depending on the facts and circumstances, the proposed requirement may apply in addition to existing requirements for addressing conflicts of interest. While existing requirements often address conflicts of interest through disclosure, certain obligations require more than disclosure to adequately address conflicts. For instance, under both the fiduciary standard and Reg BI, disclosure of conflicts alone does not necessarily satisfy the applicable standard of conduct. As noted above, under these standards, certain conflicts should (and in some cases, must) be addressed through elimination or mitigation.193 Similarly, when a firm uses covered technology in an investor interaction involving a conflict of interest, scalability can make disclosure of the conflict unachievable in many circumstances such that disclosure alone would be insufficient to adequately address the conflicts of interest. This is because a conflict can replicate to a much greater magnitude and at a much greater speed than would be possible to address through timely disclosure. We recognize that many investor interactions could have the sole goal of encouraging investors to open a new account, and that firms may use covered technologies for this purpose. The proposed conflicts rules would not require conflicts of interest that exist 191 See supra note 80. while compliance with the proposed rule’s requirements could help address compliance with Reg BI’s Conflict of Interest Obligation, a broker-dealer that makes a recommendation to retail customers would still be subject to Reg BI’s other component obligations. 193 See, e.g., Fiduciary Interpretation, supra note 8, at nn.67–70 (discussing informed consent); Reg BI Adopting Release, supra note 8, at text accompanying nn.17–19 (discussing the Conflict of Interest Obligation’s requirement for broker-dealers to identify and disclose, eliminate or mitigate conflicts associated with recommendations to retail customers). 192 Moreover, E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules solely due to a firm seeking to open a new investor account to be eliminated or their effect neutralized. Even though opening an account would likely be in the interest of the firm, the proposed conflicts rules are not designed to limit firms’ abilities to attract clients and customers. However, as noted above, incentivizing specific types of activity (such as margin or options trading privileges, as opposed to opening a general account, or investing in a particular type of investment, as opposed to just opening an account to invest) that is particularly profitable to a firm (and is not always in investors’ interest), is intentionally addressed by the proposed conflicts rules. We request comment on all aspects of the proposed conflicts rules’ elimination or neutralization requirement, including the following items: 52. Considering that the proposed conflicts rules’ elimination or neutralization evaluation requirement may overlap with existing regulatory requirements for broker-dealers and investment advisers, would firms’ compliance with those other regulatory requirements contribute to compliance with the proposed conflicts rules, and vice versa? If so, in what ways? 53. Are our concerns correct that scalability could rapidly exacerbate the magnitude and potential effect of the conflict in a way that could make full and fair disclosure and informed consent unachievable? Are there some conflicts that are more appropriately addressed by disclosure than others? Does this depend on the kind of investor interaction or kind of technology? For example, is scalability more problematic when an investor directly uses a covered technology than when an associated person communicates recommendations or advice that the associated person has generated using covered technology? 54. The elimination or neutralization requirement would also require firms to eliminate, or neutralize the effect of, conflicts of interest associated with use or potential use of a covered technology by an associated person of a firm. What challenges, if any, would firms face due to this aspect of the proposed conflicts rules? Should we make any changes as a result? Instead of or in addition to covering conflicts of interest associated with associated persons’ use of covered technologies, should we prescribe any additional requirements, such as additional diligence or policies and procedures, relating to conflicts of interest associated with associated persons? In addition to natural persons, should the elimination or neutralization requirement apply in the context of VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 entities controlling, controlled by, or under common control with firms? 55. Should firms be required to eliminate, or neutralize the effect of, conflicts of interest that place the firm’s interests ahead of investors’ interests as required under the proposed rules? Instead, should the elimination or neutralization obligation (or the requirements of sections (b)(1) or (b)(2) of the proposed conflicts rules) be limited to investor interactions involving, as applicable, investment advice or recommendations by a firm or its associated persons (or by a covered technology employed by a firm or its associated persons)? Should that obligation or requirements be limited to investor interactions directly with covered technologies? What other ways could we address the risks that conflicts of interest associated with firms’ use of covered technologies will result in investor interactions that place the firm’s interest ahead of the investor interest? 56. Is the requirement to eliminate, or neutralize the effect of, certain conflicts of interest sufficiently clear? Should we provide any additional guidance on what we mean by ‘‘neutralize the effect of’’? If so, how? Instead of, or in addition to, elimination and neutralization, should the proposed conflicts rules require mitigation of some or all of the effects of conflicts of interest determined to place a firm’s interests ahead of investors’ interests under section (b)(2) of the proposed conflicts rules? If so, which conflicts? Is there additional guidance we should provide, or changes we should make to the text of the proposed conflicts rules, to clarify the distinction between elimination or neutralization, on the one hand, and mitigation, on the other hand? 57. Are there particular methods that firms currently use to eliminate, or neutralize the effect of, conflicts of interest in investor interactions using covered technology? Should we indicate that certain methods (including limiting access to the technology, providing policies and procedures for ‘‘safe’’ use of the technology, limiting the data the technology considers, providing ‘‘counterweights,’’ or training the algorithm to ignore certain information) are methods we believe are generally appropriate to eliminate, or neutralize the effect of, conflicts of interest under the proposed conflicts rules or that certain methods are not appropriate for compliance with the proposed conflicts rules? If we were to provide additional guidance, how should we ensure that the proposed conflicts rules’ requirement to eliminate, or neutralize PO 00000 Frm 00031 Fmt 4701 Sfmt 4702 53989 the effect of, conflicts is sufficiently general that it would continue to apply to future technologies or future conflicts we may not currently anticipate as such technologies develop? Is using a ‘‘counter-signal’’ to train a learning model a useful way to eliminate, or neutralize the effect of, conflicts associated with the model? In addition to the testing requirement in section (b)(1) of the proposed conflicts rules, should we also require that firms that are eliminating, or neutralizing the effect of, conflicts of interest test the covered technology after such elimination or neutralization to determine whether it was successful? 58. Is our understanding correct that the proposed conflicts rules, including the proposed elimination or neutralization requirement, are consistent with the applicable standards of conduct? To what extent will firms be able to utilize existing methods of addressing conflicts of interest and existing policies and procedures in order to comply with the proposed conflicts rules? For example, do firms expect to utilize their existing methods of addressing conflicts of interest under Reg BI or the fiduciary standard, as applicable, in order to comply with the proposed conflicts rules? 59. The proposed investment adviser conflict prohibition would only apply to investment advisers registered or required to be registered under section 203 of the Advisers Act, meaning certain firms, including exempt reporting advisers and state-registered advisers, would not be covered. Should the prohibition be expanded to cover these entities? If the investment adviser conflict prohibition is widened to capture these entities, should the policies and procedures requirement in paragraph (c) of the proposed conflicts rules be similarly widened? Would certain types of advisers, such as those that primarily provide advice through an interactive website, be disproportionately affected by this proposal? Would any such advisers seek to restructure their operations to avoid this result? We are separately proposing updates to the internet adviser exemption, 17 CFR 275.203A–2. Should we modify any aspect of the proposed conflicts rules in order to coordinate with the proposed updates to the internet adviser exemption? 194 60. How do firms currently ensure their use of what the proposal would define as covered technologies complies 194 See Exemption for Certain Investment Advisers Operating Through the internet, Investment Advisers Act Release No. 6354 (July 26, 2023). E:\FR\FM\09AUP2.SGM 09AUP2 53990 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules with applicable existing rules and regulations or other legal obligations, including standards of conduct? Do firms using ‘‘black box’’ algorithms currently rely on disclosure instead of or in addition to affirmative design steps to address the actual and potential conflicts of interest associated with such algorithms? If so, what disclosure do firms provide and what form of informed consent do investors provide regarding firms’ use of such algorithms? How do firms comply with the applicable standard of conduct, including the duty to act in the investor’s best interest, particularly where they have been unable to determine whether their interests are being placed ahead of their investors? 61. Is the exclusion for the use of covered technologies in investor interactions that have the sole goal of encouraging investors to open a new account sufficiently clear? Should this exclusion be narrowed or broadened, and, if so, how? For example, should we provide that the exclusion is only available if a firm does not differentially market to investors in order to guide them to open a particular type of account that is especially profitable for the firm, such as an options or margin account? lotter on DSK11XQN23PROD with PROPOSALS2 3. Policies and Procedures Requirement The proposed investment adviser conflicts rule would require every investment adviser that is subject to paragraph (b) of the rule and uses covered technology in any investor interaction to adopt and implement written policies and procedures reasonably designed to prevent violations of paragraph (b) of that rule.195 Likewise, the proposed brokerdealer conflicts rule would require every broker-dealer that is subject to paragraph (b) of that rule and that uses covered technology in any investor interaction to adopt, implement, and maintain written policies and procedures reasonably designed to achieve compliance with paragraph (b) of that rule.196 For all firms, these 195 See proposed rule 211(h)(2)–4(c)(3). See also discussion of proposed conflicts rules at paragraphs (b)(1) through (3) supra section II.A.2. As noted above, the definition of ‘‘investor interaction’’ ‘‘does not apply to interactions solely for purposes of meeting legal or regulatory obligations or providing clerical, ministerial, or general administrative support.’’ See proposed conflicts rules at paragraph (a) and discussion supra section II.A.1.b. 196 See proposed rule 15l–2(c). Under the Commission’s rules, investment advisers historically have been required to ‘‘adopt and implement’’ policies and procedures that are ‘‘reasonably designed to prevent violation’’ of the Advisers Act or rules adopted thereunder, while broker-dealers have been required to ‘‘establish, maintain, and enforce’’ policies and procedures that VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 policies and procedures would need to include: (i) a written description of the process for evaluating any use or reasonably foreseeable potential use of a covered technology in any investor interaction pursuant to paragraph (b)(1) of the proposed conflicts rules and a written description of any material features of, including any conflicts of interest associated with the use of, any covered technology used in any investor interaction prior to such covered technology’s implementation or material modification, which must be updated periodically; 197 (ii) a written description of the process for determining whether any conflict of interest identified pursuant to paragraph (b)(1) of the proposed conflicts rules results in an investor interaction that places the interest of the firm or its associated persons ahead of the interests of the investor; 198 (iii) a written description of the process for determining how to eliminate, or neutralize the effect of, any conflicts of interest determined pursuant to paragraph (b)(2) of the proposed conflicts rules to result in the interest of the investment adviser, broker-dealer, or the firm’s associated persons being placed ahead of the interests of the investor; 199 and (iv) a review and written documentation of that review, no less frequently than annually, of the adequacy of the policies and procedures and written descriptions established pursuant to this policies and procedures requirement and the effectiveness of their implementation. Although it is possible that some firms that use covered technology in investor interactions may not identify any conflicts of interest in carrying out the requirements of paragraph (b)(1) of the proposed conflicts rules, such firms are ‘‘reasonably designed to achieve compliance with’’ the particular rule. Compare 17 CFR 206(4)– 7(a) (investment advisers required to ‘‘adopt and implement written policies and procedures reasonably designed to prevent violation’’) with 17 CFR 240.15l–1(a)(2)(iv) (broker dealers required to ‘‘establish[ ], maintain[ ], and enforce[ ] written policies and procedures reasonably designed to achieve compliance with’’). In order to assist firms with compliance with the proposed conflicts rules’ policies and procedures requirements, we have used language that is consistent with these respective rules. Accordingly, the wording of the proposed policies and procedures requirements varies between investment advisers and brokerdealers. We do not believe, however, that there is a substantive difference between how firms would need to comply with each proposed rule. See, e.g., Reg BI Adopting Release, supra note 8, at text accompanying n.810 (discussing policies and procedures requirements for investment advisers and broker-dealers without noting any difference despite the differing language). 197 Proposed conflicts rules at (c)(1). 198 Proposed conflicts rules at (c)(2). 199 Proposed conflicts rules at (c)(3). PO 00000 Frm 00032 Fmt 4701 Sfmt 4702 would still be required to adopt, implement, and, in the case of brokerdealers, maintain these written policies and procedures, so as to be prepared to address any instance where such a conflict of interest is later identified by the firm in the course of its ongoing operations. These proposed policies and procedures requirements are designed to help ensure that a firm understands how its covered technologies work when engaging in any investor interaction using covered technologies, the conflicts of interest those covered technologies present, and the potential effects of those conflicts on investors.200 Further, these proposed requirements are designed to help ensure that firms will not place their own interests ahead of the interests of investors where such conflicts of interest are associated with the firm’s use of covered technology. A firm’s failure to adopt and implement (and, in the case of broker-dealers, maintain) these policies and procedures would constitute a violation of the proposed conflicts rules independent of any other securities law violation. As a result, the proposed conflicts rules would address the failure of a firm to adequately describe how a covered technology works and the actual or potential conflicts the technology’s use could create with the interests of investors before any such conflicts cause actual harm to investors. We are proposing minimum standards for the written descriptions and annual review that a firm’s policies and procedures would need to include. However, the proposed conflicts rules would provide firms with flexibility to determine the specific means by which they address each element, and the degree of prescriptiveness the firm includes in their policies and procedures. To satisfy the proposed conflicts rules’ requirement to have policies and procedures including the specified written descriptions and annual review, firms generally should take into consideration the nature of their operations, and account for the covered technologies in use or to be used. Further, in satisfying the proposed conflicts rules, a firm should account for any use or reasonably foreseeable potential use of a covered technology that does or could result in conflicts of 200 The policies and procedures requirements complement the elimination and neutralization requirement, and are intended to encourage development of risk-based best practices by firms, rather than to impose a one-size-fits-all solution. Cf. Chamber of Commerce AI Report, supra note 144, at 89 (discussing necessity of firms deploying certain technologies ‘‘having sufficient understanding of the system to provide effective human oversight’’). E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules interest in light of the firm’s particular operations. For example, under the proposed conflicts rules, the level of detail firms would need to include when producing a written description of any material features of any covered technology used in any investor interaction, and the conflicts of interest associated with the use of that technology, will generally be less for those firms that either engage in a very limited use of covered technology, or that only use covered technologies that are relatively simple. On the other hand, for a firm that makes extensive use of more complex covered technology, such as machine learning technologies that function automatically without direct interaction with firm personnel, or a firm whose conflicts of interest are more complex or extensive, the policies and procedures would need to be substantially more robust. This could include consideration of all aspects of the covered technologies the firm uses, including the data used to train the technologies, ‘‘explainability’’ requirements, specific training for technical staff, and maintaining (and regularly reviewing) logs sufficient to identify any risks the firm’s use of a covered technology presents of noncompliance with the proposed conflicts rules. In addition to the requirements outlined in paragraphs (c)(1)–(4) of the proposed conflicts rules, firms designing policies and procedures reasonably designed to achieve compliance with paragraph (b) of the proposed conflicts rules generally should consider including other elements, as appropriate, such as: (i) compliance review and monitoring systems and controls; (ii) procedures that clearly designate responsibility to appropriate personnel for supervision of functions and persons; (iii) processes to escalate identified instances of noncompliance to appropriate personnel for remediation; and (iv) training of relevant personnel on the policies and procedures, as well as the forms of covered technology used by the firm. We request comment on all aspects of the scope of the proposed conflicts rules’ policies and procedures requirement, including the following items: 62. Does the proposed conflicts rules’ policies and procedures requirement complement, overlap with, or duplicate the existing regulatory framework for broker-dealers and investment advisers? If so, in what ways? Specifically, would firms’ compliance with those other regulatory requirements contribute to VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 compliance with the proposed conflicts rules, and vice versa? 63. Are all aspects of these proposed policies and procedures requirements, as well as the particular written descriptions and review to be required by a firm’s policies and procedures, necessary and appropriate for achieving compliance with paragraph (b) of the proposed conflicts rules? If not, what elements should be added, deleted, or modified to better ensure firms’ compliance with paragraph (b) of the proposed conflicts rules? 64. Several aspects of the proposed conflicts rules address conflicts of interest associated with use or potential use of a covered technology by an associated person of a firm; should any aspect of the proposed policies and procedures requirement be changed as a result? For example, instead of, or in addition to, maintaining an explicit reference to a firm’s associated persons in paragraph (b) of the proposed conflicts rules, should we prescribe any additional requirements, such as additional diligence or policies and procedures, relating to conflicts of interest of firms’ associated persons? 65. Is the scope of firms covered by the proposed policies and procedures requirement appropriate in light of the requirements of paragraph (b) of this proposed rule? Should the proposed rule be modified to only require these policies and procedures of those firms that have identified at least one conflict of interest in their evaluation of any covered technology that is used or that it is reasonably foreseeable that the firm could potentially use in any investor interaction? 66. Should the proposed rule require that senior firm personnel and/or specific technology subject-matter experts participate in the process of adopting and implementing these policies and procedures? If so, which parties, and what should be their required scope of responsibilities? Further, should any senior firm personnel and/or specific technology subject-matter experts be required to certify that such policies and procedures that the firm adopts and implements are in compliance with the requirements of this paragraph (c) of the proposed conflicts rules? Would there be costs associated with such participation or certification? If so, what are they? When designing their policies and procedures, should firms be required to include some or all of the following: (i) compliance review and monitoring systems and controls; (ii) procedures that clearly designate responsibility to appropriate personnel for supervision of functions and PO 00000 Frm 00033 Fmt 4701 Sfmt 4702 53991 persons; (iii) processes to escalate identified instances of noncompliance to appropriate personnel for remediation; and (iv) training of relevant personnel on the policies and procedures, as well as the forms of covered technology used by the firm? a. Written Description of Evaluation Process To Identify Conflicts of Interest and Written Description of Material Features Under the proposed policies and procedures requirement, firms would need to adopt and implement (and, in the case of broker-dealers, maintain) written policies and procedures reasonably designed to achieve compliance with paragraph (b) that include a written description of the process for evaluating any use or reasonably foreseeable potential use of a covered technology in any investor interaction pursuant to paragraph (b)(1), and a written description of the material features of, including any conflicts of interest associated with the use of, any covered technology used in any investor interaction.201 The proposed requirement to include a written description of the process for evaluating any use or reasonably foreseeable potential use of a covered technology in any investor interaction within the firm’s written policies and procedures is designed to help ensure the firms establish and follow a defined process for evaluating any use or reasonably foreseeable potential use of a covered technology in any investor interaction and consequently identifying any conflict of interest associated with that use or potential use, as required by paragraph (b)(1). Although the scope of any individual evaluation may depend on a variety of factors, including the specific covered technology in question, the manner in which that covered technology would interact with investors, and how the technology may be used, this process generally should be designed to provide firms with a consistent approach to satisfying the requirements of paragraph (b)(1) of the proposed conflicts rules. This written description would assist firms in performing the vital initial step of identifying all relevant conflicts of interest, which is necessary to ultimately complying with the proposed conflicts rules’ requirement to eliminate, or neutralize the effect of, those conflicts of interest that place or result in placing the interest of the firm or its associated persons ahead of the interests of the investor. In addition to assisting the firm’s internal staff, this 201 Proposed E:\FR\FM\09AUP2.SGM conflicts rules at (c)(1). 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 53992 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules written description of the process that firms will use would assist the Commission’s examinations staff in assessing the firm’s compliance with the entirety of the proposed conflicts rules. This written description must articulate a process for the firm to use in evaluating any use or reasonably foreseeable potential use of a covered technology by the firm or its associated persons in any investor interaction to identify any conflict of interest associated with that use or potential use. Further, this process must address how the firm will conduct the required testing of each such covered technology prior to its implementation or material modification, and periodically thereafter, to determine whether the use of such covered technology is associated with a conflict of interest. Although we recognize that this process must be flexible enough to account for different types of covered technologies and investor interactions that those technologies might be used in, the firm’s written description generally should be specific enough to ensure the consistent identification of any associated conflicts of interest. The process described by the firm generally should detail those steps it will take in conducting this evaluation, as well as the means it will use in identifying each relevant conflict of interest. To further promote compliance with the evaluation and identification required under paragraph (b)(1), a firm’s policies and procedures would be required to include a written description of the material features of any covered technology used in any investor interaction, including any conflicts of interest associated with the use of the covered technology, and would need to be prepared prior to its implementation or material modification, and updated periodically. As discussed above, we are concerned that some firms currently lack a holistic understanding of the covered technologies they employ, and that this could result in investor interactions that are based on unknown conflicts of interest that are harmful to the investor.202 These concerns are heightened when firm personnel who are responsible for ensuring the covered technology complies with applicable laws and regulations, including SRO rules, do not fully understand how the covered technology would work in interactions with investors, and, thus, the risks the covered technology might present to those investors. 202 See supra section I.B (background discussion on conflicts of interest). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 The proposed written description element is designed to address these risks in a manner that helps ensure that the firm has identified and developed an understanding of those conflicts of interest that might impact the firm’s investor interactions through the use of covered technology. The material features of a covered technology generally would include how the technology works, including how it optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes, in a manner that would enable the appropriate personnel at a firm to understand the potential conflicts of interest associated with the technology. Further, firms generally should include within this written description detail on when and how the firm intends to use, or could reasonably foresee using, the covered technology in investor interactions. To the extent that the outcomes of the technology are difficult or impossible to explain (e.g., in the case of a ‘‘black box’’), the description of how any associated conflicts arise would be critical to informing the application of the firm’s elimination or neutralization procedures. As discussed above, the Commission is aware that some more complex covered technologies lack explainability as to how they function in practice, and how they reach their conclusions.203 The proposed conflicts rules would apply equally to these covered technologies, and firms would only be able to continue using them where all requirements of the proposed conflicts rules are met, including the requirements of paragraph (c). As discussed above, as a practical matter, it would be impossible for firms to use such covered technologies and meet the requirements of paragraph (b) of the proposed conflicts rules where they are unable to identify all conflicts of interest associated with the use of such covered technology.204 For similar reasons, if a firm is incapable of preparing this written description of all such conflicts of interest associated with the use of the covered technology in any investor interaction as a result of the lack of explainability of the analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process comprising the covered technology, as well as its resulting outcomes, it would not be possible for the firm to satisfy the requirements paragraph (c) of the proposed conflicts rules. However, similar to the discussion above, where 203 See supra section II.A.2.a (discussion on Evaluation and Identification). 204 See id. PO 00000 Frm 00034 Fmt 4701 Sfmt 4702 firms are not able to satisfy the requirements of paragraph (c) of the proposed conflicts rules with a particular covered technology in its current form, firms may be able to modify these technologies, for example by embedding explainability features into their models and adopting back-end controls in a manner that will enable firms to satisfy these requirements.205 A high degree of specificity may not be necessary when creating the written description of every material feature of any covered technology used by the firm in any investor interaction. For example, if a material feature could not reasonably be expected to be associated with a conflict of interest (e.g., a financial model that is used to compute whether risks are sufficiently diversified in a portfolio containing various asset classes), a firm could reasonably determine that a simple description of that feature would be sufficient. However, at a minimum, it would need to describe the material features of the covered technology used by the firm at a level of detail sufficient for the appropriate personnel at the firm to understand whether its use would be associated with any conflicts of interest. A firm would be required to update this written description periodically. This requirement is designed to help ensure that firms are appropriately monitoring their use of covered technologies and accurately memorializing any material features of any covered technology that the firm uses in any investor interaction. These periodic updates to the written description should occur where a covered technology has been upgraded or materially modified in a manner that would make the previously existing written description inaccurate or incomplete. Additionally, if firm personnel become aware of either additional material features of the covered technology used by the firm, or of the firm engaging in a different use of the covered technology that was not previously contemplated by the written description, the written description should be updated at that time to include such information. We request comment on all aspects of this proposed written description requirement found in paragraph (c)(1) of the proposed conflicts rules, including the following items: 67. Does the proposed conflicts rules’ requirement that firms include written descriptions as part of their policies and procedures complement, overlap with, or duplicate the existing regulatory framework for broker-dealers and 205 See E:\FR\FM\09AUP2.SGM id. 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules investment advisers? If so, in what ways? Specifically, would firms’ compliance with those other regulatory requirements contribute to compliance with the proposed conflicts rules, and vice versa? 68. Should we require greater specificity within the written description as to the means a firm will use for evaluating any use or reasonably foreseeable potential use of covered technology in any investor interaction, in addition to a description of the firm’s process for conducting such an evaluation? If so, what additional points of specificity should be required? Should we require less specificity? Does the level of specificity in the proposed requirement allow for sufficient flexibility to administer this aspect of the policies and procedures in a variety of circumstances? 69. Should we require that the written description of the firm’s evaluation and identification process be prepared by specific firm personnel or approved by firm management? If so, by whom? Similarly, should this written description require the designation of specific individuals to carry out the process firms will use for evaluating any use or reasonably foreseeable potential use of covered technology in any investor interaction? 70. What are the challenges associated with compiling a written description of any material features of and any conflicts of interest associated with the use of any covered technology they employ? Should the proposed conflicts rules be revised to account for those challenges? If so, how? 71. As a practical matter, firms using black box technologies would find it challenging, and potentially impossible, to meet the requirements of the proposed rules to the extent they find it difficult to identify and describe all conflicts of interest associated with the use of such covered technology. In addition to these proposed requirements, should we explicitly require that any technologies used by firms must be explainable? 72. Is it sufficiently clear what features of a covered technology would constitute ‘‘material features’’ beyond those features that present conflicts of interest? If not, what additional detail should the Commission provide? Should the Commission define ‘‘material features’’ for the purpose of the proposed rule? For example, should the Commission specify as ‘‘material features’’ the types of recommendations or advice, or other investor interactions, a covered technology is designed to produce? Should the term also include the types of inputs, the specific methods VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 of analysis, or the user interface of the technology? Why or why not? 73. Is the proposed level of specificity and detail of the written description of the material features of any covered technology used by the firm in any investor interaction appropriate under the circumstances? Should the rule explicitly require that this description be sufficient for the appropriate personnel at the firm to understand whether the use of the covered technology would be associated with any conflicts of interest the appropriate standard? If not, what should be the standard? Does the level of specificity and detail still allow for flexible implementation in a variety of circumstances? 74. Is the scope of covered technologies subject to this written description requirement appropriate in light of the requirements of paragraph (b) of this proposed conflicts rules? Should the proposed conflicts rules be modified to only require a written description of the material features of those covered technologies that the firm uses in any investor interaction that the firm has identified as containing at least one conflict of interest? b. Written Description of Determination Process The proposed conflicts rules would also require that firms’ policies and procedures must include a written description of the process for determining whether any conflict of interest identified pursuant to paragraph (b)(1) of the proposed conflicts rules results in an investor interaction that places the interest of the investment adviser, broker-dealer, or the firm’s associated persons ahead of the interests of the investor.206 This requirement is designed to help ensure that firms create and implement a process for determining which of those conflicts of interest that they have identified in their use or potential use of a particular covered technology results in an investor interaction that would place the interests of that firm or its associated persons ahead of the interests of the investor. While this determination will ultimately depend on the individual conflict of interest, covered technology, related investor interactions, and other factors that may not be easily predictable, this process generally should be designed to provide a consistent approach to satisfying the requirements of paragraph (b)(2) of the proposed conflicts rules. In doing so, this written description would assist firms in performing this essential step to 206 Proposed PO 00000 Frm 00035 conflicts rules at (c)(2). Fmt 4701 Sfmt 4702 53993 ultimately comply with the requirement in paragraph (b)(3) of the proposed conflicts rules to eliminate, or neutralize the effect of, such conflicts of interest. In addition to assisting the firm’s internal staff, this written description would assist the Commission’s examinations staff in assessing the firm’s compliance with the proposed rules. This written description generally should clearly articulate the process for the firm to use in determining whether any conflict of interest that it has identified would result in placing its own interests or the interests of its associated persons ahead of the interests of investors. Although we recognize that the idiosyncrasies of differing conflicts of interest or different types of investor interactions may necessitate some manner of flexibility as to the firm’s process, the written description of the firm’s process generally should be specific enough to help ensure that the process will be consistently effective in producing determinations by the firm that accurately reflect those conflicts of interest that would result in placing the interests of the firm or its associated persons ahead of the interests of investors. The process described by the firm generally should detail certain steps for determining the effect that the conflict of interest has, or would have, on an investor interaction if the covered technology or material modification were put into use by the firm. This should include a means of determining whether the interest of the firm, or associated person, is or would be placed ahead of investors’ interests if the firm used the covered technology or a material modification to the covered technology in investor interactions. We request comment on all aspects of this proposed written description requirement found in paragraph (c)(2) of the proposed conflicts rules, including the following items: 75. Does this aspect of the proposed conflicts rules complement, overlap with, or duplicate the existing regulatory framework for broker-dealers and investment advisers? If so, in what ways? Specifically, would firms’ compliance with those other regulatory requirements contribute to compliance with the proposed conflicts rules, and vice versa? 76. Should we require the written description of the firm’s process for determining whether any conflict of interest identified pursuant to paragraph (b)(1) of the proposed conflicts rules results in an investor interaction that places the interest of the firm, or associated person, ahead of the interests of investors be prepared by specific firm E:\FR\FM\09AUP2.SGM 09AUP2 53994 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules personnel or approved by firm management? If so, by whom? Similarly, should this written description require the designation of specific individuals, such as those in legal, compliance, technology, or managerial positions, to carry out the process firms will use for determining whether a particular conflict of interest places the interest of the firm, or associated person, ahead of the interests of the investor? 77. Does the level of specificity in the proposed requirement allow for sufficient flexibility to administer this aspect of the policies and procedures in a variety of circumstances? Should we require greater specificity within the written description as to the means a firm will use for determining whether a conflict places the interest of the firm, or associated person, ahead of the interest of the investor, in addition to a description of the firm’s process for making such a determination? If so, what additional points of specificity should be required? Should we instead require less specificity? If so, what details should not be required to be included in this written description? lotter on DSK11XQN23PROD with PROPOSALS2 c. Written Description of Process for Determining How To Eliminate, or Neutralize the Effects of, Conflicts of Interest The proposed conflicts rules would also require that firms’ policies and procedures include a written description of the process for determining how to eliminate, or neutralize the effect of, any conflict of interest determined by the firm, pursuant to paragraph (b)(2) of the proposed conflicts rules, to result in an investor interaction that places the interest of the investment adviser, broker-dealer, or the firm’s associated persons ahead of the interests of the investor.207 This element is designed to require firms to have an established framework for eliminating, or neutralizing the effect of, conflicts of interest, which we believe should assist those firms in complying with paragraph (b)(3) of the proposed conflicts rules. The description will also assist the firm’s internal staff, as well as examination staff, in assessing a firm’s compliance. The process for elimination or neutralization that a firm sets forth in the written description should be tailored to account for the differing circumstances presented to the firm when making its determination as to a 207 Proposed conflicts rules at (c)(3); see also proposed conflicts rules at (b)(2) requiring such determination by the firm, discussed supra section II.A.2.d. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 particular conflict of interest. For example, the process described by the firm should account for whether the particular conflict of interest involves a covered technology that is already being used in investor interactions, or instead only involves a conflict of interest from a reasonably foreseeable potential use. Where the process pertains to a reasonably foreseeable potential use, the firm should address how its personnel would determine whether a covered technology has been sufficiently modified such that any identified conflicts of interest have been eliminated, or their effect has been neutralized, prior to any use in an investor interaction. However, if the firm is already using the covered technology in any of its investor interactions, the firm’s written description of this process must address how it would promptly eliminate, or neutralize the effect of, any identified conflict of interest. The written process for a covered technology that is already used in investor interactions might, for example, require the firm to immediately limit access to or use of the technology or, if possible, immediately eliminate the identified conflict of interest, prior to considering further modifications.208 In either instance, the firm would need to include a written description of the steps that the firm would take under its elimination or neutralization procedures to prevent any investor interaction that places the interest of the firm ahead of the interests of investors (e.g., by explicitly eliminating consideration of the factors that reflect the firm’s interest, by disabling a part of the technology, by training it to use reinforcement learning to prioritize investors’ interest in all cases, or by eliminating the business practice that is associated with the conflict). To support their efforts at compliance with the proposed conflicts rules, firms using covered technologies in investor interactions could consider providing additional training to staff who will be implementing their elimination and neutralization policies. For example, firms may benefit from providing additional training to their staff responsible for maintaining the covered technologies in order to give them a better understanding of the legal framework governing their firm’s use of covered technologies. In addition, firms may consider providing additional technical training to relevant personnel, so that they are better able to 208 Additional discussion of how firms may eliminate, or neutralize the effect of, conflicts of interest may be found above supra section II.A.2.e. PO 00000 Frm 00036 Fmt 4701 Sfmt 4702 understand how the covered technologies that the firm uses work, and as a result can better understand the technical aspects of what is necessary to eliminate or neutralize a given conflict of interest. Because a firm’s policies and procedures would need to address all covered technologies used by the firm in any investor interaction, and each conflict of interest involving such covered technologies, this written description should contain a clear articulation of the process the firm uses for determining how a conflict should be eliminated or its effect neutralized. In addition, when a firm’s policies and procedures dictate a specific means of making such a determination, the firm’s written description would need to reflect this. We request comment on all aspects of this proposed written description requirement found in paragraph (c)(3) of the proposed conflicts rules, including the following items: 78. Does this aspect of the proposed conflicts rules complement, overlap with, or duplicate the existing regulatory framework for broker-dealers and investment advisers? If so, in what ways? Specifically, would firms’ compliance with those other regulatory requirements contribute to compliance with the proposed conflicts rules, and vice versa? 79. Should we require greater specificity within the written description as to the means a firm will use for determining whether and how a conflict should be eliminated or neutralized, in addition to a description of the firm’s process for making such a determination? If so, what additional points of specificity should be required? Should we require less specificity? Does the level of specificity in the proposed requirement allow for sufficient flexibility to administer this aspect of the policies and procedures in a variety of circumstances? 80. Should we require that the written description of the firm’s elimination or neutralization process be prepared by specific firm personnel or approved by firm management? If so, by whom? Similarly, should this written description require the designation of specific individuals to carry out the process firms will use for determining how a particular conflict of interest must be eliminated or neutralized? 81. Should a firm’s policies and procedures be required to specifically address the conduct of individuals? For example, should a firm’s policies and procedures be required to address conflicts of interest where all of the benefit may accrue to one of the firm’s E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 personnel, such as when firm personnel took an action that is designed to increase their own compensation regardless of the overall impact on the firm? If those persons are not registered or required to be registered as an investment adviser, broker, or dealer, would their actions otherwise be covered by the firm’s policies and procedures? d. Annual Review of the Adequacy and Effectiveness of the Policies and Procedures and Written Descriptions The proposed conflicts rules would also require that the policies and procedures include a review and a written documentation of that review, no less frequently than annually, of the adequacy of the policies and procedures established under the proposed conflicts rules and the effectiveness of their implementation, as well as a review of the written descriptions established pursuant to this section.209 During this review, firms would need to specifically evaluate whether their policies and procedures and written descriptions have been adequate and effective over the period under review at achieving compliance with the proposed conflicts rules’ requirements to identify and evaluate all instances where their use or potential use of a covered technology in an investor interaction involves a conflict of interest, determine whether that conflict of interest places the interest of the investment adviser, broker-dealer, or an associated person of the firm ahead of those of the investor, and to then eliminate, or neutralize the effect of, any such conflict of interest promptly after the firm has, or reasonably should have, identified the conflict. Further, firms generally should use this annual review to consider whether there have been any changes in the business activities of the firm or its associated persons, any changes in its use of covered technology generally, any issues that arose from its use of covered technologies during the previous year, any changes in applicable law, or any other factor that might suggest that certain covered technologies now present a different or greater risk than the firm’s policies and procedures and written descriptions had previously accounted for, and what adjustments might need to be made to such documents or their implementation to address these risks. Firms would also be required to prepare written documentation of the review that they have conducted. Such documentation would serve to assist firms in assessing their compliance with all obligations under the proposed conflicts rules, and any related adjustments to their policies and procedures and written descriptions that might be necessary. To the extent that firms’ annual review identifies any policies and procedures and written descriptions as being inadequate or ineffective, firms would need to make sure that they are in compliance with the requirement to establish and implement, and in the case of brokerdealers, maintain, policies and procedures that are reasonably designed to achieve compliance with the proposed conflicts rules. Under 17 CFR 275.206(4)–7 (‘‘Advisers Act Compliance Rule’’), an investment adviser is required to adopt and implement written policies and procedures reasonably designed to prevent violation, by the adviser and its supervised persons, of the Advisers Act and the rules thereunder as well as review, no less frequently than annually, the adequacy of the policies and procedures established pursuant to the Advisers Act Compliance Rule and the effectiveness of their implementation. Any policies and procedures an investment adviser adopts under the proposed conflicts rules could be reviewed in conjunction with the annual review under the Advisers Act Compliance Rule. While the Commission has no parallel rule requiring annual review of a brokerdealer’s policies and procedures for their adequacy and effectiveness, a broker-dealer that is a FINRA member is required to ‘‘establish, maintain, and enforce written procedures to supervise the types of business in which it engages and the activities of its associated persons that are reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable FINRA rules.’’ 210 In addition, each FINRA member broker-dealer must ‘‘have its chief executive officer(s) (or equivalent officer(s)) certify annually . . . that the member has in place processes to establish, maintain, review, test and modify written compliance policies and written supervisory procedures reasonably designed to achieve compliance with applicable FINRA rules, MSRB 211 rules and Federal securities laws and regulations, and that the chief executive officer(s) has conducted one or more meetings with the chief compliance officer(s) in the preceding 12 months to discuss such 210 See 209 Proposed VerDate Sep<11>2014 conflicts rules at (c)(4). 19:26 Aug 08, 2023 Jkt 259001 FINRA Rule 3110(b)(1). 211 Municipal Securities Rulemaking Board. PO 00000 Frm 00037 Fmt 4701 Sfmt 4702 53995 processes.’’ 212 Those broker-dealers who would be subject to the proposed conflicts rule could conduct this annual review in conjunction with their required review and certification obligations under FINRA’s rules, in order to increase the organizational efficiency and likely effectiveness of this annual review. We request comment on all aspects of this proposed annual review requirement found in paragraph (c)(4) of the proposed conflicts rules, including the following items: 82. Does this aspect of the proposed conflicts rules complement, overlap with, or duplicate the existing regulatory framework for broker-dealers and investment advisers? If so, in what ways? Specifically, would firms’ compliance with those other regulatory requirements contribute to compliance with the proposed conflicts rules, and vice versa? 83. Should we limit the scope of the annual review requirement for policies and procedures relating to certain covered technologies, or types of covered technologies? For example, if a covered technology has not changed in the past year, or if a covered technology were considered low risk for creating conflicts or changing since the last year, and the firm has not modified how it uses the covered technology, would it still be necessary to require firms to conduct a review in that area? If we were to limit the scope of the annual review requirement, should we require firms to monitor changes in technology more generally in order to be aware of whether, even if the covered technology itself has not changed, its interaction with other technologies in use by the firm could create conflicts of interest? What limitations would be necessary and appropriate to account for any risk of potential harm to investors if such limitations on the scope of the annual review requirement were provided? 84. Should we require more or less frequent reviews? For example, monthly, quarterly, or every other year? Should we require the review be conducted by specific firm personnel, such as a technology compliance specialist? If so, by whom? B. Proposed Recordkeeping Amendments We are proposing to amend rules 17a– 3 and 17a–4 under the Exchange Act and rule 204–2 under the Advisers Act to set forth requirements for brokerdealers and investment advisers to 212 See FINRA Rule 3130(b); see also FINRA Rule 3130(c) detailing procedures required for such certification. E:\FR\FM\09AUP2.SGM 09AUP2 53996 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 maintain and preserve, for the specific retention periods,213 all books and records related to the requirements of the proposed conflicts rules. The proposed recordkeeping amendments would also include making and maintaining six specific types of records discussed in detail below. These proposed recordkeeping amendments are designed to work in concert with the proposed conflicts rules to help ensure that a record with respect to a firm’s use of covered technology is maintained and preserved in easily accessible locations for an appropriate period of time consistent with existing recordkeeping obligations. The proposed retention periods also conform to existing retention periods for broker-dealers and investment advisers. This approach is intended to allow firms to minimize their compliance costs by integrating the proposed requirements into their existing recordkeeping systems and record retention timelines. The proposed retention periods also conform to existing rules by having consistent requirements for maintaining records in an easily accessible location.214 And, as with other recordkeeping rules, the proposed recordkeeping amendments would help both the firm’s compliance staff, as well as examinations staff (including relevant SRO staff, as applicable), assess the firm’s compliance with the requirements of the proposed conflicts rules. First, firms would be required to make and maintain written documentation of the evaluation, pursuant to paragraph (b)(1) of the proposed conflicts rules, of any conflict of interest associated with the use or potential use by the firm or associated person of a covered technology in any investor interaction.215 This written documentation would include a list or other record of all covered technologies used by the firm in investor interactions, including: (i) the date on which each covered technology is first implemented (i.e., first deployed), and each date on which any covered technology is materially modified, and 213 For broker-dealers, rule 17a–4(a) under the Exchange Act would require that records be ‘‘preserve[d] for a period of not less than 6 years, the first two years in an easily accessible place.’’ For investment advisers, rule 204–2(e)(1) under the Advisers Act provides that records, including those under the proposed recordkeeping amendments, ‘‘shall be maintained and preserved in an easily accessible place for a period of not less than five years from the end of the fiscal year during which the last entry was made on such record, the first two years in an appropriate office of the investment adviser.’’ 214 See id. 215 Proposed 17 CFR 240.17–3(e)(36)(i); 17 CFR 275.204–2(a)(24)(i). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 (ii) the firm’s evaluation of the intended use as compared to the actual use and outcome of the covered technology.216 Firms would also be required to make and maintain documentation describing any testing of the covered technology performed under paragraph (b)(1) of the proposed conflicts rules, including: (i) the date on which testing was completed; 217 (ii) the methods used to conduct the testing; (iii) any actual or reasonably foreseeable potential conflicts of interest identified as a result of the testing; (iv) a description of any changes or modifications made to the covered technology that resulted from the testing and the reason for those changes; and (v) any restrictions placed on the use of the covered technology as a result of the testing.218 This documentation generally should include, for example, a record of any research or third-party outreach the firm conducted related to any testing of a covered technology that is performed under the proposed conflicts rules. This information would assist examinations staff, who would have a record they can reference when assessing compliance. This information also may assist firms in evaluating their initial testing methodologies and in evaluating and, where appropriate, remediating instances when the intended use or outcome of a covered technology differs from its actual use or outcome. In some instances, for example where the covered technology is using relatively straightforward mathematical models such as those contained in spreadsheets, firms could simply list all such technologies as a single entry, which we anticipate would ease firms’ compliance with the proposed recordkeeping amendments for these technologies. Second, firms would be required to make and maintain written documentation of the determination, pursuant to paragraph (b)(2) of the proposed conflicts rules, whether any conflict of interest identified pursuant to paragraph (b)(1) of the proposed conflicts rules places the interest of the firm, or associated person of a firm, ahead of the interests of the investor. This would include the rationale for such determination.219 This written 216 See id. id. We are aware that in certain cases, for example when complex technologies are involved, testing could take longer than one day. We propose that this requirement would refer to the date the testing was completed so that staff are able to assess whether the firm frequently relies on ‘‘stale’’ information. 218 See id. 219 Proposed 17 CFR 240.17a–3(e)(36)(ii); 17 CFR 275.204–2(a)(24)(ii). 217 See PO 00000 Frm 00038 Fmt 4701 Sfmt 4702 documentation of the rationale generally should include, for example, the basis on which a firm concludes that a conflict did or did not result in an investor interaction that places the firm or associated person’s interests ahead of an investor. This information would assist examinations staff, who would have records they can reference when assessing compliance with the proposed conflicts rules. This information also may assist firms in determining whether actual or reasonably foreseeable potential conflicts of interest place the interests of the firm, or an associated person of the firm, ahead of the interests of the investor, as well as reviewing the effectiveness of the policies and procedures to achieve compliance with this requirement pursuant to paragraph (c). Third, firms would be required to make and maintain written documentation evidencing how the effect of any conflict of interest has been eliminated or neutralized pursuant to paragraph (b)(3) of the proposed conflicts rules.220 This written documentation generally should include a record of the specific steps taken by the firm (i.e., show your work) in deciding how to eliminate, or neutralize the effects of, any conflicts of interest as required under the proposed conflicts rules. The written documentation also generally should include the rationale for any determination to make changes or modifications to or place restrictions on the covered technology 221 to eliminate, or neutralize the effect of, any identified conflicts of interest, the methodology used to make any such determination, and a description of the firm’s analysis that resulted in any such determination. This information would assist examinations staff, who would have records they can reference when assessing compliance. This information also may assist firms in the determination of how to eliminate or neutralize conflicts of interest, as well as reviewing the effectiveness of the policies and procedures to achieve compliance with this requirement pursuant to paragraph (c). Fourth, firms would be required to maintain the written policies and procedures, including any written descriptions, adopted, implemented, and, with regard to broker-dealers, maintained pursuant to paragraph (c) of the proposed conflicts rules.222 This documentation would include the date 220 Proposed 17 CFR 240.17a–3(e)(36)(iii); 17 CFR 275.204–2(a)(24)(iii). 221 See proposed 17 CFR 240.17a–3(e)(36)(i); 17 CFR 275.204–2(a)(24)(i). 222 Proposed 17 CFR 240.17a–3(e)(36)(iv); 17 CFR 275.204–2(a)(24)(iv). E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules on which the policies and procedures were last reviewed.223 Firms must also maintain written documentation evidencing a review, occurring at least annually, of the adequacy of the policies and procedures established pursuant to paragraph (c) of the proposed conflicts rules, and the effectiveness of their implementation, as well as a review of the written descriptions established pursuant to paragraph (c) of the proposed conflicts rules. These provisions would assist examinations staff in assessing firms’ compliance with the proposed conflicts rules. To help demonstrate compliance with the proposed conflicts rules, a firm may elect to maintain records documenting other information regarding covered technology, which could help to demonstrate that it took a reasonable approach when identifying and evaluating the conflicts of interest associated with the technology. For example, a firm may choose to maintain a record of any uses, other than in investor interactions, that the firm reasonably foresees for each covered technology.224 Fifth, firms would be required to make and maintain a record of any disclosures provided to investors regarding the firm’s use of covered technologies, including, if applicable, the date such disclosure was first provided or the date such disclosure was updated.225 We do not intend this proposed requirement to impose new disclosure requirements, nor do we intend that firms maintain documents in two locations. Many firms could satisfy this proposed requirement by maintaining a simple bullet-point list with cross-references to all disclosures they make to investors regarding their use of covered technologies (whether the disclosure is made pursuant to an existing requirement or voluntarily). Maintaining a list of any such disclosures would assist examinations staff in reviewing disclosures given to investors regarding a firm’s use of covered technologies, to help ensure that these disclosures are full and fair. Sixth, firms would be required to make and maintain records of each instance in which a covered technology was altered, overridden, or disabled; the reason for such action; and the date thereof. This requirement would include making and maintaining records of all instances where an investor requested that a covered technology be 223 See id. id. 225 Proposed 17 CFR 240.17a–3(e)(36)(v); 17 CFR 275.204–2(a)(24)(v). altered or restricted in any manner.226 We believe these records will assist in identifying which technologies may present higher risks, for example if they require constant alterations or if certain investors request that such technologies not be used on their accounts. We request comment on all aspects of the proposed recordkeeping amendments, including the following items: 85. Do the proposed recordkeeping amendments complement, overlap with, or duplicate the existing regulatory framework for broker-dealers and investment advisers? If so, in what ways? Specifically, would firms’ compliance with those other regulatory requirements contribute to compliance with the proposed recordkeeping amendments, and vice versa? 86. Are there additional records that firms would naturally create as they complied with the proposed conflicts rules that we should require them to maintain? Are there any records beyond what firms would already naturally create that would be useful to require them to maintain? Should we require fewer records? If so, which ones should we eliminate and why? 87. Would the records that firms would be required to make and retain under the proposed recordkeeping amendments likely require firms to retain additional ‘‘backup’’ documentation, such as logs, training data, or other documentation? Should we make any changes as a result? For example, should we explicitly require such information to be made and retained? Are there reasons such information should not be required to be made and retained? For example, is it likely that such information would be voluminous, and could therefore be difficult for firms to retain for the full timeframe that records would be required to be maintained? If so, should we reduce the time that firms would be required to retain such records? 88. For records related to all instances where an investor requested that a covered technology be altered or restricted, what challenges would firms face with respect to maintaining this information? What factors should we consider if we qualify this requirement? 89. Are the proposed periods of time for preserving records appropriate, or should certain records be preserved for different periods of time? If records should be preserved for different periods of time, which records should have different time periods and what should those periods of time be? 90. We are proposing to require broker-dealers and investment advisers to maintain the same records. Are there any differences in the way that investment advisers and broker-dealers conduct business that would advocate for maintaining different sets of records? 91. Should the proposed recordkeeping requirement that advisers maintain records of all instances where an investor requested that a covered technology be altered or restricted in any manner apply to prospective clients and prospective investors in a pooled investment vehicle? Should an investment adviser be required to maintain a record of instances where a prospective client or prospective investor in a pooled investment vehicle requested that the covered technology be altered or restricted, but the investment adviser rejected the request, and the prospective client did not ultimately invest? 92. We are proposing to require firms to maintain a record of any disclosures provided to each investor regarding the firm’s use of covered technologies. Should the proposed recordkeeping amendments require specific disclosures to be provided or maintained? If so, what disclosures? Should the disclosures be limited to use of covered technologies in investor interactions, or be broadened to include more technology? Should we also require records of disclosures about a firm’s or associated person’s conflicts associated with the use of such technologies in investor interactions? 93. We are proposing to require firms to make and maintain documentation describing any testing of the covered technology performed under paragraph (b)(1) of the proposed conflicts rules. Along with the existing specifics, should we also require information about who developed and/or conducted the testing (e.g., firm personnel, an outside vendor)? III. Economic Analysis A. Introduction The Commission is sensitive to the economic consequences and effects, including costs and benefits, of its rules. Section 3(f) of the Exchange Act 227 and section 202(c) of the Advisers Act 228 provide that when engaging in rulemaking that requires it to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will 224 See VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 226 Proposed 17 CFR 240.17a–3(e)(36)(vi); 17 CFR 275.204–2(a)(24)(vi). PO 00000 Frm 00039 Fmt 4701 Sfmt 4702 53997 227 15 228 15 E:\FR\FM\09AUP2.SGM U.S.C. 78c(f). U.S.C. 80b–2(c). 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 53998 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules promote efficiency, competition, and capital formation. Additionally, section 23(a)(2) of the Exchange Act 229 requires the Commission, when making rules under the Exchange Act, to consider the impact such rules would have on competition. Section 23(a)(2) also provides that the Commission shall not adopt any rule which would impose a burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act. The analysis below addresses the likely economic effects of the proposed conflicts rules and proposed recordkeeping amendments, including the anticipated benefits and costs of the proposed rules and amendments, and their likely effects on efficiency, competition, and capital formation. Where practicable, the Commission quantifies the likely economic effects of the proposed rules and amendments; however, the Commission is unable to quantify certain economic effects because it lacks the information necessary to provide estimates or ranges. Some of the benefits and costs discussed below are impracticable to quantify because quantification would necessitate general assumptions about behavioral responses that would be difficult to quantify. The Commission is providing both a qualitative assessment and, where feasible, a quantified estimate of the economic effects. The Commission seeks comment on any data that could aid quantification of these responses. The proposed conflicts rules and proposed recordkeeping amendments may have economic implications for investors, investment advisers, and broker-dealers, and could also affect third-party service providers. The proposed conflicts rules would introduce requirements to identify conflicts of interest associated with the use of covered technologies in investor interactions and eliminate or neutralize those conflicts that place or result in placing the interest of the firm or associated person ahead of the interest of the investor, as well as proposed recordkeeping requirements regarding such determinations and resulting actions. This economic analysis aims to examine the potential benefits and costs of the proposed rules and amendments and the impact the proposed rules and amendments may have on the market’s efficiency, competition, and capital formation. B. Broad Economic Considerations In the last two decades and after the proliferation of internet-based services, 229 15 U.S.C. 78w(a)(2). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 the advent of new technologies has modified the business operations of broker-dealers and investment advisers.230 Access to cheaper and more granular data, plus the additional availability of advanced computing power, have advanced data collection and processing techniques. These developments have significantly enhanced the scale and scope of data analytics and their potential applications by investment advisers and broker-dealers in their interactions with investors. These advances have increased the ability of each of these investor interactions to contain conflicted conduct, given the more widespread availability of data about investors, advances in user interface design and gamification, and business practices that could place the firm’s or an associated person’s interest ahead of investors’ interests. Also, some PDA-like technologies are now able to update their interactions with investors dynamically, based on information or data they have gained from their users or from other data sources, which can dynamically alter the nature and scope of conflicts of interest. The capabilities of these technological advances—including the data the technology uses (including any investor data) and the inferences the technology makes (including in analyzing investor data, other data, securities, or other assets)—may be opaque to investors and firms. This opacity makes it more challenging for an investor to identify the presence of a conflict of interest, understand its importance, and take protective action when making an investment decision or otherwise interacting with the firm. Likewise, a firm’s identification of such conflicts is more challenging without unique efforts to both fully understand the PDA-like technology it is using and oversee conflicts that are created by or transmitted through such technology for purposes of the firm’s compliance with applicable Federal securities laws. Further, PDA-like technologies can have the capacity to process data, scale outcomes from analysis of data, and evolve at incredibly rapid rates. These traits could rapidly and exponentially scale the effects of any conflicts of interest associated with such technologies, which could impact the markets more broadly.231 230 See supra section I.B. supra sections I.A and I.B. For example, a firm may use PDA-like technologies to automatically develop advice and recommendations that are then transmitted to investors through the firm’s chatbot, mobile trading app, and roboadvisory platform. If the advice or recommendation is tainted by a conflict of interest, that conflict 231 See PO 00000 Frm 00040 Fmt 4701 Sfmt 4702 The Commission considered two broad economic themes raised by firms’ use of covered technology in investor interactions. First, the use of covered technology in investor interactions can entail conflicts of interest related to the principal-agent problem between firms and investors, and second, the use of complex and opaque technologies can potentially create events that can harm investors.232 The principal-agent problem arises when one party, known as the principal, hires an agent to perform a task on the principal’s behalf, but the interests of the principal and the agent are not aligned.233 The principal-agent problem can result in the agent acting in its own self-interest ahead of the principal’s interest. This problem is particularly relevant in the financial industry, where firms manage investments or execute orders on behalf of investors in exchange for fees. Firms usually have more information about the investments they are recommending, pricing, and market dynamics than the investors that they serve, and can potentially place their interests ahead of investors’ interests. Similarly, firms can encourage investors to use more services, or increase transactions, potentially placing the firm’s interest over investors’ interests. These conflicts of interest are exacerbated by firms’ use of certain covered technologies because the technologies that firms use may be complex and opaque to investors, who may not have the knowledge or time to understand how firms’ use of these technologies may generate conflicts of interest in their interactions with investors. If these conflicts of interest were left unaddressed, investors could be harmed by less efficient investment would rapidly reach many investors. See supra note 16 and surrounding text. 232 The proposed conflicts rules’ definition of ‘‘conflict of interest’’ is broader than how economists usually define ‘‘conflicts of interest’’ such as in the context of the principal-agent problem. One economist’s definition of ‘‘conflict of interest’’ is ‘‘a situation in which a party to a transaction can potentially gain by taking actions that adversely affect its counterparty.’’ Hamid Mehran & Rene´ M. Stulz, The Economics of Conflicts of Interest in Financial Institutions, 85 J. Fin. Econ. 267–296 (Aug. 2007). 233 Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305 (1976) (‘‘Jensen & Meckling’’). E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 strategies 234 and incur agency costs.235 This could also adversely affect the formation of capital, as investors might choose to invest less or might lose confidence in capital markets. Disclosure can sometimes help address conflict of interest problems in principal-agent relationships. When firms fully and fairly disclose conflicts of interest, investors may be able to make informed decisions about their investments. For example, investment advisers are required to provide clients with a Form ADV, which details information about the adviser’s business practices, fees, and certain conflicts of interest.236 The Commission has brought enforcement actions against broker-dealers that failed to disclose certain conflicts to customers.237 In addition, investment advisers and broker-dealers are required to provide ‘‘retail investors’’ with Form CRS, which explains fees, commissions, and other information that may be relevant when choosing a firm.238 These disclosure requirements provide investors with information that may help them choose among firms. They also help to create a more transparent relationship between a firm and its investors and potentially help investors assess whether investment advisers and broker-dealers are placing their own interests ahead of their investors’ interests. In section III.C.3, we discuss the current disclosures that investment advisers and broker-dealers are required to make in addition to other obligations, and in section III.D.1, we discuss why we believe disclosure is unlikely to be sufficient to address the principal-agent problems generated by covered technologies.239 234 A rational investor seeks out investment strategies that are efficient in the sense that they provide the investor with the highest possible expected net benefit, in light of the investor’s investment objective that maximizes expected utility. See, e.g., Andreu Mas-Colell, Michael D. Whinston & Jerry R. Green, Chapter 10: Competitive Markets for a Discussion of Efficient Allocations of Resources, in Microeconomic Theory (1995). 235 The difference between the net benefit to the investor from accepting a less than efficient recommendation about a securities transaction or investment strategy, where the associated person or broker-dealer puts its interests ahead of the interests of the investor’s interests, and the net benefit the investor might expect from a similar securities transaction or investment strategy that is efficient for him or her, is an agency cost. See, e.g., Jensen & Meckling, supra note 233 for a more general discussion of agency costs. 236 Amendments to Form ADV, Investment Adviser Act Release No. 3060 (July 28, 2010) [75 FR 49233 (Aug. 12, 2010)] (‘‘Amendments to Form ADV’’). 237 See supra note 64. 238 Fiduciary Interpretation, supra note 8. 239 See also Reg BI Adopting Release, supra note 8, at III.B.4.c. (discussing the effectiveness and limitations of disclosure). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 Firms may adopt certain DEPs in the use of covered technology in investor interactions that can exploit common biases or tendencies in investors and lead these investors to make investment decisions that will place the firm’s interest ahead of investors’ interests.240 These practices can exacerbate the principal-agent problem, as disclosure might not be as effective at addressing the misaligned incentives between the firm and the investor. For example, firms could use demographic information about an investor or their risk-taking behavior to encourage them to take actions that place the firm’s interest ahead of the investors’ interest.241 These could be actions such as trading unnecessarily, allowing the firm to collect extra fees or payments from the additional trading activity (e.g., through increased commissions or payment for order flow) or investing in riskier positions that are more profitable to the firm.242 Studies have shown, for example, that excess trading has a negative impact on investment returns, with frequent traders exhibiting lower net annual returns than infrequent traders due to overconfidence.243 Other studies have found that some stock trading apps appear to follow strategies employed by some firms in the gambling industry to 240 Ontario Securities Commission, Staff Notice 11–796, Digital Engagement Practices in Retail Investing: Gamification and Other Behavioural Techniques (2022), https://www.osc.ca/sites/ default/files/2022-11/sn_20221117_11-796_ gamification-report.pdf. George M. Korniotis & Alok Kumar, Do Portfolio Distortions Reflect Superior Information or Psychological Biases?, 48 J. Fin. Quant. Analysis 1 (2013) (‘‘Korniotis’’); Thomas Dohmen et al., Individual Risk Attitudes: Measurement, Determinants, and Behavioral Consequences, 9 J. Eur. Econ. Ass’n 522–550 (June 2011) (‘‘Thomas Dohmen et al.’’); Brad M. Barber & Terrance Odean, Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors, 55 J. Fin. 773– 806 (2000) (‘‘Trading Is Hazardous’’); Brad M. Barber & Terrance Odean, Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment, 116 Q. J. Econ. 261–292 (Feb. 2001) (‘‘Boys Will Be Boys’’); Marie Grall-Bronnec et al., Excessive Trading, a Gambling Disorder in its Own Right? A Case Study on a French Disordered Gamblers Cohort, 64 Addictive Behav. 340–348 (Jan. 2017); M. Mosenhauer, et al., The Stock Market as a Casino: Associations Between Stock Market Trading Frequency and Problem Gambling, 10 J. Behav. Addictions 683–689 (Sept. 2021); Alex Bradley & Richard JE James, Defining the Key Issues Discussed by Problematic Gamblers on Web-based Forums: A Data-driven Approach, 21 Int’l Gambling Stud. 59–73 (2021). 241 For example, attitudes toward risk and risktaking behavior have been found to be meaningfully predicted by sex, age, height, and parental educational achievement. See Dohmen, et al., supra note 240. 242 Korniotis, supra note 240. 243 See, e.g., Trading is Hazardous, supra note 240. PO 00000 Frm 00041 Fmt 4701 Sfmt 4702 53999 encourage frequent repeat betting,244 obscure costs, and offer complex instruments with lottery-like large payoffs in rare cases, and that these behavior-influencing strategies benefit from survivorship bias.245 These practices might not constitute recommendations, and therefore might not face the same obligations that recommendations would. In addition, given that these strategies exploit psychological biases and innate tendencies of the investor rather than information deficiencies or asymmetries, even comprehensive, accurate, and legible disclosure might be less effective at ensuring disinterested investor interactions, including recommendations, which do not place the firm’s interest above that of investors.246 Firms could profit from these strategies through increased fees or payment for order flow due to higher transaction frequency and higher fees on more complex trades, among other means. In contrast to these strategies, initial efforts at design research as applied to financial applications identified several practices that could improve investor thoughtfulness and informed decision-making.247 The scale and scope of investor interactions that are now possible with new technologies, and the scope and dynamic nature of the conflicts of interest that can be generated by or associated with firms’ use of covered technology, present challenges for the use of disclosure to address conflicts of interest. A single, large disclosure at the beginning of the firm’s relationship with the investor might be too lengthy to be meaningful or actionable, or not specific enough to be effective, because it would have to capture the full set of conflicts of interest that could evolve dynamically, across investors, through the use of PDA-like technologies, especially if the technology rapidly adjusts in response to prior interactions 244 Philip W.S. Newall & Leonardo Weiss-Cohen, The Gamblification of Investing: How a New Generation of Investors Is Being Born to Lose, 19 Int. J. Env’t. Res. Pub. Health (Apr. 28, 2022). 245 M.W. Brandt & J.A. Gaspar, Trading on Margin: The Effect of Financial Market Information Services and Trading Apps on Day Trading Behavior, 33 Rev. Fin. Stud. 2331–2372 (2020). 246 Human behavior exhibits conditioned responses. See William S. Verplanck, The operant conditioning of human motor behavior, 53 Psychological Bulletin 70 (1956). Moreover, the anticipation of monetary rewards creates similar neural circuitry to anticipation of primary rewards in other primates. See B. Knutson et al., FMRI visualization of brain activity during a monetary incentive delay task, 12 Neuroimage, 20–27 (2000). 247 Chaudhury & Kulkarni, supra note 53, at 777– 788. E:\FR\FM\09AUP2.SGM 09AUP2 54000 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules with an investor.248 Alternatively, attaching a disclosure to each individual investor interaction could address the potential for conflicts of interest that are dynamically generated through the use of PDA. However, the overall large number of disclosures would impose costs on firms and investors, and effectiveness of these disclosures might be reduced because of the sheer quantity of disclosures.249 Firms’ use of PDA-like technologies could also impact markets more broadly, because these technologies can process data and amend analytical outcomes at incredibly fast rates, thereby creating unanticipated conflicts of interest that can affect numerous investors, and create market disruptions that affect market participants broadly.250 A given firm might not fully bear the cost of the use of these technologies, and thus might not fully internalize the full cost of the use of these technologies. The costs imposed on entities external to the firm are called negative externalities, and regulatory intervention may be needed to address these costs. C. Economic Baseline 1. Affected Parties Broadly, the proposed rules would affect investment advisers, brokerdealers, and investors. They could also indirectly affect third-party service providers that provide covered technologies used by these parties. As of February 28, 2023, there were 15,402 investment advisers registered with the Commission 251 and 3,504 broker-dealers registered with the Commission.252 There were 308,565 individuals registered with FINRA as broker-dealer representatives only, 80,977 individuals registered as investment adviser representatives only, 312,317 individuals registered as both investment adviser and broker-dealer representatives, and a total of 971,758 employees reported by investment advisers.253 However, because the proposed rules would also affect associated persons of firms these numbers may undercount the number of affected individuals, because not all associated persons of a firm are registered representatives of the firm. Approximately 73.5% of registered broker-dealers report retail customer activity.254 Form ADV requires investment advisers to indicate the approximate number of advisory clients and the amount of total regulatory assets under management (‘‘RAUM’’) attributable to various client types.255 Table 1 provides information on the number of client accounts, total RAUM, and the number of advisers by client type. TABLE 1—CLIENTS OF INVESTMENT ADVISERS FROM FORM ADV Total RAUM (billions) Client type Investment Companies ................................................................................................................ Pooled Investment Vehicles—Other ............................................................................................ High Net Worth Individuals .......................................................................................................... Pension Plans .............................................................................................................................. Insurance Companies .................................................................................................................. Non-High Net Worth Individuals .................................................................................................. State/Municipal Entities ............................................................................................................... Corporations ................................................................................................................................ Foreign Institutions ...................................................................................................................... Charities ....................................................................................................................................... Other Advisers ............................................................................................................................. Banking Institutions ...................................................................................................................... Business Development Companies ............................................................................................. lotter on DSK11XQN23PROD with PROPOSALS2 256 $42,955 34,433 11,664 7,807 7,623 7,030 4,214 3,198 2,194 1,580 1,385 903 213 Clients (millions) 0.022 0.094 6.898 0.442 0.015 44.092 0.029 0.348 0.003 0.127 0.904 0.011 0.000 RIAs 1,565 5,897 9,166 5,429 1,381 8,493 1,608 5,196 752 5,369 1,202 825 97 As of February 2023, 50,554 private funds were reported on Form PF, and 5,620 registered investment advisers listed private funds on their Form ADV.257 The effects of the proposed rules to firms and associated persons would be contingent on a number of factors, such as, among others, the types of covered technologies the firm uses, the number of current and prospective clients or customers of the firm, the number of investors in pooled investment vehicles advised by the firm, the frequency of investor interactions, and the nature and extent of the conflicts of interest. Because of the wide diversity of services and relationships offered by firms, we expect that the obligations imposed by the proposed rules would, accordingly, vary substantially. The Commission seeks public comment on the number and type of these affected parties. When developing the baseline, we considered how current trends in technological development and the conflicts associated with them might reasonably affect financial markets in the absence of the proposed rules. The Commission invites public comment on our characterization of these trends in the baseline. The proposed rules would affect investors. As discussed earlier in this release, the proposed rules would define ‘‘investor’’ differently for investment 248 See e.g., Maartje Elshout, et al., Study on consumers’ attitudes towards Terms and Conditions (T&Cs), European Commission Final Report (2016); Uri Benoliel & Shmuel I. Becher, The Duty to Read the Unreadable, 60 B. C. L. Rev. 2255 (2019); Yannis Bakos, et al., Does Anyone Read the Fine Print? Consumer Attention to Standard-Form Contracts, 43 J. Legal Stud. 1 (2014). 249 Due to the potential scalability of these disclosures, incremental costs for firms might be de minimis, but these disclosures would still take costly effort by investors to interpret. 250 SEC Staff Report, Equity and Options Market Structure Conditions in Early 2021 (Oct. 4, 2021) (‘‘GameStop Report’’), https://www.sec.gov/files/ staff-report-equity-options-market-structionconditions-early-2021.pdf. 251 Based on IARD data as of Mar. 27, 2023. 252 Based on SEC data as of Mar. 1, 2023, https:// www.sec.gov/help/foiadocsbdfoia. 253 Based on FOCUS Filing data, as of March 2023. 254 Consistent with the Form CRS Adopting Release, we estimate that 73.5% of registered broker-dealers report retail activity and thus, would likely be subject to the proposed conflicts rule. However, we recognize this may capture some broker-dealers that do not have retail activity. 255 If a client fits into more than one category, Form ADV requires an adviser to select one category that most accurately represents the client (to avoid double counting clients and assets). 256 This report reflects analysis of Form ADV data downloaded from the Enterprise Data Warehouse as of February 28, 2023. Form ADV, Items 5C, 5D, and 5F(2)(c). Prior to the October 2017 changes to Form ADV, clients and client RAUM were estimated based on the midpoint of ranges reported. 257 SEC, Div. of Investment Mgmt, Analytics Office, Private Funds Statistics Third Calendar Quarter 2022, (Apr. 6, 2023). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 PO 00000 Frm 00042 Fmt 4701 Sfmt 4702 E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 advisers as compared to broker-dealers. For investment advisers, ‘‘investor’’ is defined as any prospective or current client of an investment adviser or any prospective or current investor in a pooled investment vehicle advised by the investment adviser. For brokerdealers, ‘‘investor’’ is defined to mean a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes. This definition is identical to the one used for ‘‘retail investor’’ in Form CRS, and it excludes non-retail investors of broker-dealers. According to the Federal Reserve Board’s 2019 Survey of Consumer Finances, a total of 41.3 million U.S. households have either an individual retirement account (‘‘IRA’’) or a brokerage account; an estimated 23.0 million U.S. households have a brokerage account, and 32.7 million households have an IRA (including 63% of households that also hold a brokerage account).258 Households have increased their use of business professionals for investment decisions, rising from 48.9 percent in 2001 to 56.5 percent in 2019. In addition, household use of the internet for investment decisions has risen from 14.8 percent in 2001 to 45.2 percent in 2019.259 A 2019 survey of households found that approximately 10 million U.S. households use roboadvisers.260 In 2022, the top 10 roboadvisers reported $353.2 billion in assets under management.261 The Commission seeks comment on the number of investors this definition could cause to be affected by the proposed conflicts rules, and the extent and nature of the use of covered technologies. The proposed conflicts rules may indirectly affect third-party service providers of covered technologies. A firm may be using a covered technology developed by a third-party service provider, including through some license agreement with the third-party 258 The data is obtained from the Federal Reserve System’s 2019 Survey of Consumer Finances (‘‘SCF’’). See Board of Governors of the Fed. Rsrv. Sys., Survey of Consumer Finances (2019), https:// www.federalreserve.gov/econres/scfindex.htm. 259 See Neil Bhutta et al., Board of Governors of the Fed. Rsrv. Sys., 106 Fed. Rsrv. Bulletin 31 (Sept. 2020) (‘‘Business professionals’’ combines seven options: accountant, banker, broker, financial planner, insurance agent, lawyer, and real estate agent). 260 Michael Mackenzie, Demand for Advice Rises as Not All Investors Go It Alone, Fin. Times (Sept. 13, 2020), https://www.ft.com/content/3900c943245a-424d-b2e5-da6128655ed5. 261 Barbara Friedberg, Top-10 Robo-Advisors by Assets under Management, Forbes Advisor (July 9, 2022), https://www.forbes.com/advisor/investing/ top-robo-advisors-by-aum/. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 service provider. A firm may also outsource certain functionality of the covered technology to, or utilize the support or services of, a third-party provider for a variety of reasons, including cost efficiencies, increased automation, particular expertise, or functionality that the firm does not have in-house. Based on Commission staff experience, the Commission believes that these third-party providers play a growing role with respect to the development of covered technologies, and the Commission anticipates that third-party providers will likely arise to provide other types of functionality, service, or support to firms that are not contemplated yet today. Due to data limitations, we are unable to quantify or characterize in much detail the structure of these various service provider markets. The Commission lacks specific information on the exact extent to which third-party service providers are retained, the specific services they provide, and the costs for those services. We also do not have information about the market for these services, including the competitiveness of such markets. We request information from commenters on the services related to covered technologies provided by third parties to firms, the costs for those services, and the nature of the market for these services. 2. Technology and Market Practices The use of technology in investing has undergone significant transformation in recent years.262 Some firms and investors in financial markets now use new technologies such as AI, machine learning, NLP, and chatbot technologies to communicate and make investment decisions.263 In addition, improvements and new applications for existing technologies for data-analytics, data collection, and investor interaction continue to be developed.264 Financial market participants currently use AI and machine learning technologies in a variety of ways. For example, algorithmic trading is a widely used application of machine learning in finance, where machine-learning models analyze large datasets and identify patterns and signals to optimize, forecast, predict, guide, or direct investment-related behaviors or outcomes.265 Several banks and other 262 See supra section I.A; see Shaw & Gani, supra note 75. 263 Kearns & Nevmyvaka, supra note 24; Thier & dos Santos Monteiro, supra note 24. 264 Lekh & Pa ´ tek, supra note 25; Martindale, supra note 25. 265 Forecasting in contexts contemplated by these rules, such as machine learning, involves PO 00000 Frm 00043 Fmt 4701 Sfmt 4702 54001 financial institutions have developed chatbots to assist with customer service and support, and have attempted to make the chatbot interactions feel similar to conversations with humans.266 These chatbots can help customers with a range of tasks, from checking account balances and transactions to making payments and disputing fraudulent charges. NLP is used to analyze financial news and social media data, identifying trends and sentiment that may influence market behavior. For instance, hedge funds and trading firms use NLP tools to analyze financial news articles, press releases, and social media posts in realtime, to identify patterns and make trading decisions based on sentiment analysis.267 Some robo-advisers use chatbots and NLP technology to provide investment advice via online platforms.268 These platforms may use a combination of AI, machine learning, NLP, and chatbot technologies to provide personalized investment recommendations to investors based on risk tolerance and investment goals. Recent advancements in data collection techniques have significantly enhanced the scale and scope of data analytics and its potential applications. Thanks to increases in processing power and data storage capacity, a vast amount of data is now available for high-speed analysis using these technologies.269 Furthermore, the range of data types has also expanded, with consumer shopping estimation of a future value based on data which includes a temporal component. Prediction, in contrast, is the more general estimation of unknown data from known data, for example, missing words in a transcript. See, e.g., Mattias Do¨ring, Prediction vs Forecasting, Data Science Blog (Dec. 9, 2018), https://www.datascienceblog.net/post/machinelearning/forecasting_vs_prediction/. 266 See, e.g., Suman Bhattacharyya, Bank of America Wants a Human Bridge for Its AI Help, BankingDive (Dec. 12, 2022), https:// www.bankingdive.com/news/bank-america-ericachatbot-virtual-assistant-human-middleinteraction-gopalkrishnan/638523/; Sara Castellanos, Capital One Brings ‘Humanity’ to Its Forthcoming Chatbot, CIO Blog (July 19, 2017), https://www.wsj.com/articles/capital-one-bringshumanity-to-its-forthcoming-chatbot-1500488098 (retrieved from Factiva database); Moise, supra note 24. 267 See, e.g., Patrick Henry & Dilip Krishna, Making the Investment Decision Process More Naturally Intelligent, Deloitte Insights (Mar. 2, 2021), https://www2.deloitte.com/us/en/insights/ industry/financial-services/natural-languageprocessing-investment-management.html; see also Yong Chen et al., Sentiment Trading and Hedge Fund Returns, 76 J. Fin. 2001 (Apr. 8, 2011). 268 See supra note 41 and surrounding text. 269 See, e.g., Andriosopoulos et al., supra note 51; Lawler et al., supra note 51; Alex Padalka, Tech Firms Court Fidelity for Data Heap to Build AI Systems, Fin. Advisor IQ (June 8, 2023), https:// www.financialadvisoriq.com/c/4104954/529084/ tech_firms_court_fidelity_data_heap_build_ systems. E:\FR\FM\09AUP2.SGM 09AUP2 54002 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 histories, media preferences, and online behavior now among the many types of data that data analytics can use to synthesize information, forecast financial outcomes, and predict investor and customer behavior.270 As a result, these technologies can be applied in novel and powerful, yet subtle ways, such as using data layout and formatting choices to influence trading decisions.271 Some technologies use predictive data analytics and AI/ machine learning along with detailed user data to increase user engagement, and trading activity. The use of these technologies can generate conflicts of interest if firms use these technologies to suggest or nudge users to trade more frequently on their platform, or to invest in products that are more profitable for the firm but expose investors to higher costs or risks, against investors’ interests. In addition, although investors are free to choose a firm that uses technology in a manner with which they are comfortable, investors may have to undertake costly efforts to understand how firms are using technology and to be comfortable with newer technologies used by firms, including any associated disclosures of conflicts of interest. In the case of broker-dealers, non-recommendation interactions with investors are not subject to Reg BI’s Conflict of Interest Obligation, but can still influence investor behavior in a way that places the firm’s interests ahead of investors’ interests. Many of these technologies are not directly developed by investment advisers or broker-dealers, but are instead licensed from third party providers.272 This practice can harness the economies of scale in the development and testing of a technology with broad applications, by centralizing the costs within the service provider, rather than spreading the costs across multiple firms independently developing similar technologies. However, the use of third party providers can also potentially concentrate the risks that stem from conflicts of interest from the use of these technologies if such providers are concentrated within the market serving 270 Daniel Broby, supra note 52; OECD, supra note 52. 271 See Chaudhuri & Kulkarni, supra note 53. 272 See, e.g., Karl Flinders, Banks Don’t Want to Develop Fintech In-house, Computer Wkly (Apr. 20, 2023), https://www.computerweekly.com/news/ 365535576/Banks-dont-want-to-develop-fintech-inhouse; Justin L. Mack, What Advisors Really Use Fintech For, and Why Ease of Use Matters Most: Wealthtech Weekly, Fin. Plan. (July 7, 2023), https://www.financial-planning.com/list/whatmost-financial-advisors-are-using-fintech-forwealthtech-weekly. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 covered entities and provide products or services which operate broadly similarly across their covered customers. 3. Regulatory Baseline Investment advisers and brokerdealers are currently subject to obligations under Federal securities laws and regulations, and, in the case of broker-dealers, rules of SROs (in particular, FINRA),273 which are designed to promote conduct that, among other things, protects investors, including from certain conflicts of interest.274 The specific obligations are designed for the particular practices of investment advisers and broker-dealers and, accordingly, the regulatory baseline differs for each population. a. Investment Advisers The Advisers Act establishes a Federal fiduciary duty for investment advisers, which includes a duty to eliminate or disclose conflicts of interest.275 An adviser’s fiduciary duty, which encompasses both a duty of loyalty and a duty of care,276 extends to the entire relationship between the adviser and client.277 Accordingly, an investment adviser (including one who uses PDA-like technologies) must, at all times, serve the best interest of its client and not subordinate its client’s interest to its own. In other words, an investment adviser must not place its own interest ahead of its client’s interests. As part of meeting this fiduciary duty, investment advisers must eliminate conflicts of interest— interests that might incline an investment adviser, consciously or unconsciously, to render advice that is not disinterested— or at a minimum, make full and fair disclosure of the conflict of interest such that a client can provide informed consent to the conflict.278 Under this duty, investment advisers must also make full and fair 273 See supra note 59 and surrounding text. supra note 60 and surrounding text. 275 SEC v. Capital Gains, 375 U.S. 180, 194 (1963) (‘‘Capital Gains’’). See also Investment Adviser Codes of Ethics, Investment Advisers Act Release No. 2256 (July 2, 2004) [69 FR 41695 (July 9, 2004)]; Compliance Programs of Investment Companies and Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003) [68 FR 74713 (Dec. 24, 2003)] (‘‘Compliance Programs Release’’). 276 See Fiduciary Interpretation, supra note 8, at n.15 and accompanying text. 277 See Fiduciary Interpretation, supra note 8, at section II.A. 278 See Fiduciary Interpretation, supra note 8, at section II.C; Capital Gains, supra note 275, at 191– 192 (describing a Congressional intent to ‘‘eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which was not disinterested’’). 274 See PO 00000 Frm 00044 Fmt 4701 Sfmt 4702 disclosure of all material facts relating to the advisory relationship.279 Advisers are required to provide clients with a Form ADV brochure, which details information about the adviser’s business practices, fees, and certain conflicts of interest.280 The information provided must be sufficiently specific that a client is able to understand the investment adviser’s business practices and conflicts of interests,281 and it is essential that the information be presented in a manner that clients are likely to read (if in writing) and understand.282 In addition, investment advisers (and broker-dealers) are required to provide ‘‘retail investors’’ with Form CRS, which explains fees, commissions, and other information that may be relevant when choosing a firm.283 The duty of care requires, among other things, investment advisers to provide investment advice in the client’s best interest, based on a reasonable understanding of the client’s objectives. Investment advisers are subject more generally to the antifraud provisions, including section 206 of the Advisers Act,284 which prohibits fraud or deceit upon any client or prospective client; and 17 CFR 240.10b–5 (‘‘Exchange Act rule 10b–5’’), which 279 See Fiduciary Interpretation, supra note 8, at section II.C. See also Capital Gains, supra note 275 (‘‘Failure to disclose material facts must be deemed fraud or deceit within its intended meaning.’’); Amendments to Form ADV, supra note 236 (‘‘as a fiduciary, an adviser has an ongoing obligation to inform its clients of any material information that could affect the advisory relationship’’); General Instruction 3 to Part 2 of Form ADV (‘‘Under federal and state law, you are a fiduciary and must make full disclosure to your clients of all material facts relating to the advisory relationship.’’). 280 See Amendments to Form ADV, supra note 236, at section I (‘‘Since 1979, the Commission has required each adviser registered with us to deliver a written disclosure statement to clients pursuant to rule 204–3 under the Advisers Act.’’) (citations omitted). 281 See Amendments to Form ADV, supra note 236, at n.28. 282 See Amendments to Form ADV, supra note 236, at section I. (‘‘To allow clients and prospective clients to evaluate the risks associated with a particular investment adviser, its business practices, and its investment strategies, it is essential that clients and prospective clients have clear disclosure that they are likely to read and understand.’’); see also Fiduciary Interpretation, supra note 8, at section I.C. (‘‘In order for disclosure to be full and fair, it should be sufficiently specific so that a client is able to understand the material fact or conflict of interest and make an informed decision whether to provide consent.’’) and at n.59. 283 See Form CRS, General Instructions (‘‘Under rule 17a–14 under the Securities Exchange Act of 1934 and rule 204–5 under the Investment Advisers Act of 1940, broker-dealers registered under section 15 of the Exchange Act and investment advisers registered under section 203 of the Advisers Act are required to deliver to retail investors a relationship summary disclosing certain information about the firm.’’). 284 15 U.S.C. 80b–6. E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 makes it unlawful for any person to engage in fraud or deceit upon any person. Similarly, with respect to investors in pooled investment vehicles, rule 206(4)–8 under the Advisers Act makes it unlawful to make any untrue statement of a material fact, or to omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading.285 It also makes it unlawful to engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.286 In addition, the Advisers Act Compliance Rule requires advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of the Act and the rules thereunder. In designing its policies and procedures pursuant to the Advisers Act Compliance Rule, each adviser should first identify conflicts and other compliance factors creating risk exposure for itself and its clients, and then design policies and procedures to address those risks.287 Moreover, rule 206(4)–1 under the Advisers Act prohibits advisers from disseminating any advertisement that violates any requirements of that rule, including making untrue statements of material fact or misleading omissions, and discussing with clients or investors in a private fund 288 any potential benefits connected with or resulting from the investment adviser’s services or methods of operation without providing fair and balanced treatment of any material risks or material limitations associated with the potential benefits.289 An investment adviser that uses PDAlike technology is subject to these obligations as applicable, and the fiduciary duty and the Advisers Act rules apply to an investment adviser’s conduct for the entire scope of its relationship with its client, regardless of 285 Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles, Investment Adviser Release No. 2628 (Aug. 3, 2007) [72 FR 44756 (Aug. 9, 2007)] (‘‘[Our] intent is to prohibit all fraud on investors in pools managed by investment advisers’’). 286 17 CFR 275.206(4)–8. 287 Compliance Programs Release, supra note 275. 288 As discussed above, in the case of investment advisers the proposed conflicts rules would apply with respect to an adviser’s clients as well as investors in a private fund that an adviser manages. The Commission’s existing regulatory regime under certain circumstances also applies to investors in a private fund. See, e.g., 17 CFR 275.206(4)–1, 275.206(4)–8, 240.10b–5. 289 See 17 CFR 275.206(4)–1(a). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 whether the adviser’s conduct relies on the use of technology.290 b. Broker-Dealers Broker-dealers are subject to comprehensive obligations under the Federal securities laws and SRO rules.291 For example, under the antifraud provisions of the Federal securities laws and SRO rules, brokerdealers have a duty to deal fairly with their customers and observe high standards of commercial honor and just and equitable principles of trade.292 As discussed below, these existing regulatory obligations apply generally, including to broker-dealers’ current use of technology. Broker-dealers are subject to general and specific requirements aimed at addressing certain conflicts of interest, including requirements to eliminate,293 mitigate,294 or disclose certain conflicts 290 See Fiduciary Interpretation, supra note 8, at section II.A; see, e.g., 2017 IM Guidance, supra note 115 (addressing among other things, presentation of disclosures, provision of suitable advice, and effective compliance programs). 291 These obligations cannot be waived or contracted away by customers. See Exchange Act section 29(a), 15 U.S.C. 78cc(a) (‘‘Any condition, stipulation, or provision binding any person to waive compliance with any provision of [the Exchange Act] or any rule or regulation thereunder, or any rule of a [SRO], shall be void.’’). 292 See, e.g., Duker & Duker, Exchange Act Release No. 2350 (Dec. 19, 1939) (Commission opinion) (‘‘Inherent in the relationship between a dealer and his customer is the vital representation that the customer be dealt with fairly, and in accordance with the standards of the profession.’’); see also SEC, Report of the Special Study of Securities Markets of the Securities and Exchange Commission, H.R. Doc. No. 95, at 238 (1st Sess. 1963) (‘‘An obligation of fair dealing, based upon the general antifraud provisions of the Federal securities laws, rests upon the theory that even a dealer at arm’s length impliedly represents when he hangs out his shingle that he will deal fairly with the public.’’); FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade); FINRA Rule 2020 (Use of Manipulative, Deceptive, or Other Fraudulent Devices). See also FINRA Rule 2090 (Know Your Customer) requiring the brokerdealer to know essential facts concerning every customer and the authority of each person acting on behalf of the customer; FINRA Rule 4512 (Customer Account Information) requiring the broker-dealer to know, among other things, whether the customer is of legal age. 293 See, e.g., 17 CFR 240.151–1(a)(2)(iii)(D) (requiring broker-dealers subject to Reg BI to ‘‘[i]dentify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time’’); 17 CFR 240.17a–14 (requiring brokerdealers offering services to retail investors to disclose certain conflicts of interest in their Form CRS). 294 See, e.g., 17 CFR 240.151–1(a)(2)(iii)(B) (requiring broker-dealers subject to Reg BI to ‘‘[i]dentify and mitigate any conflicts of interest associated with such recommendations that create an incentive for a natural person who is an associated person of a broker or dealer to place the interest of the broker, dealer, or such natural person ahead of the interest of the retail customer’’); FINRA PO 00000 Frm 00045 Fmt 4701 Sfmt 4702 54003 of interest.295 Disclosure obligations related to conflicts of interest include disclosures before or at inception of the customer relationship.296 For example, broker-dealers (and investment advisers) are required to provide ‘‘retail investors’’ with Form CRS, which includes disclosures about, among other things, fees, commissions and firm- and financial professional-level conflicts of interest such as incentives created by the ways the firm makes money and Rule 3110(c)(3) (firm must have procedures to prevent the effectiveness of an internal inspection from being compromised due to conflicts of interest); FINRA Rule 3110(b)(6)(C) (supervisory personnel generally cannot supervise their own activities); FINRA Rule 3110(b)(6)(D) (firm must have procedures reasonably designed to prevent the required supervisory system from being compromised due to conflicts of interest). In addition, FINRA rules establish restrictions on the use of non-cash compensation in connection with the sale and distribution of mutual funds, variable annuities, direct participation program securities, public offerings of debt and equity securities, investment company securities, real estate investment trust programs, and the use of non-cash compensation to influence or reward employees of others. See FINRA Rules 2310, 2320, 2331, 2341, 5110 and 3220. These rules generally limit the manner in which members can pay or accept noncash compensation and detail the types of non-cash compensation that are permissible. 295 See supra note 68 and surrounding text explaining that a broker-dealer may be liable if it does not disclose ‘‘material adverse facts of which it is aware.’’ For example, when engaging in transactions directly with customers on a principal basis, a broker-dealer violates Exchange Act Rule 10b–5 when it knowingly or recklessly sells a security to a customer at a price not reasonably related to the prevailing market price and charges excessive markups without disclosing the fact to the customer. See, e.g., Grandon v. Merrill Lynch, 147 F.3d 184, 189–90 (2d Cir. 1998). In addition, Exchange Act Rule 10b–10 requires a broker-dealer effecting transactions in securities (other than U.S. savings bonds or municipal securities) to provide written notice to the customer of certain information specific to the transaction at or before completion of the transaction, including the capacity in which the broker-dealer is acting (i.e., agent or principal) and any third-party remuneration it has received or will receive). See also 17 CFR 240.15c1–5 and 17 CFR 240.15c1–6, which require a broker-dealer to disclose in writing to the customer if it has any control, affiliation, or interest in a security it is offering or the issuer of such security. There are also specific, additional obligations that apply, for example, to recommendations by research analysts in research reports and to public appearances under Regulation Analyst Certification (AC). See, e.g., 17 CFR 242.500 et seq. Moreover, 17 CFR 240.15l–1(a)(2)(i)(B) requires broker-dealers subject to Reg BI to fully and fairly ‘‘disclose [a]ll material facts relating to conflicts of interest that are associated with the recommendation.’’ Finally, SRO rules apply to specific situations, such as FINRA Rule 2124 (Net Transactions with Customers); FINRA Rule 2262 (Disclosure of Control Relationship with Issuer), and FINRA Rule 2269 (Disclosure of Participation or Interest in Primary or Secondary Distribution). 296 The Form CRS relationship summary requires disclosure of the broker-dealer’s services, fees, costs, conflicts of interest and disciplinary history. See 17 CFR 240.17a–14. E:\FR\FM\09AUP2.SGM 09AUP2 54004 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 how it compensates its financial professionals.297 Additionally, broker-dealers are liable under the antifraud provisions for failing to disclose material information to their customers when they have a duty to make such disclosure, including disclosures associated with the use of PDA-like technologies.298 Specifically, the antifraud provisions prohibit brokerdealers from making misstatements or misleading omissions of material facts, and fraudulent or manipulative acts and practices, in connection with the purchase or sale of securities.299 Broker-dealers are subject to Reg BI when the broker-dealer, or an associated person of the broker-dealer, makes a recommendation of a securities transaction, or an investment strategy involving securities (including an account recommendation), to a retail customer. Reg BI requires that brokerdealers and associated persons act in the best interest of the retail customer at the time a recommendation is made, without placing the financial or other interest of the broker-dealer or an associated person making the recommendation ahead of the interests of the retail customer.300 This includes a requirement to have a reasonable basis to believe that a series of recommended transactions is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile.301 297 See 17 CFR 240.17a–14; Form CRS, Instruction to Item 3.B.(ii) of Form CRS (requiring firms to summarize the incentives created by certain ways in which they make money, including incentives crated by proprietary products); Form CRS, Instruction Item 3.C.(i)(requiring firms to summarize how their financial professionals are compensated, and the conflicts of interest those payments create). 298 See Basic v. Levinson, 485 U.S. 224, 239 n.17 (1988). Generally, under the antifraud provisions, a broker-dealer’s duty to disclose material information to its customer is based upon the scope of the relationship with the customer, which depends on the relevant facts and circumstances. See, e.g., Conway v. Icahn, 16 F.3d 504, 510 (2d Cir. 1994) (‘‘A broker, as agent, has a duty to use reasonable efforts to give its principal information relevant to the affairs that have been entrusted to it.’’). 299 See, e.g., Exchange Act Sections 10(b) and 15(c). Broker-dealers may also be held liable under the Securities Act [of 1933] if ‘‘in the offer or sale’’ of any securities, the broker-dealer (1) employs any device, scheme, or artifice to defraud, (2) obtains money or property by means of any untrue statement of a material fact or any omission to state a material fact, or (3) engages in any practice which operates as a fraud or deceit upon the purchaser. See Securities Act of 1933 Section 17(a); see also Aaron v. SEC, 446 U.S. 680 (1980) (holding that violations of Section 17(a)(1) require proof of scienter, but that violations of 17(a)(2) and (3) do not). 300 Reg BI Adopting Release, supra note 8, at n.549 and surrounding text. 301 17 CFR 240.15l–1(a)(2)(ii)(C); Reg BI Adopting Release, supra note 8. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 Broker-dealers and, as applicable, their associated persons, satisfy the general obligation of Reg BI by complying with four specified component obligations: Disclosure, Care, Conflict of Interest, and Compliance.302 Reg BI, among other things, requires that broker-dealers address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest. In instances where the Commission has determined that disclosure is insufficient to reasonably address a conflict, the requirement is to mitigate or, in certain cases, eliminate the conflict. Section 17(a) of the Securities Act of 1933 and Exchange Act rule 10b–5 both prohibit fraud and deceit in the context of an offer, purchase, or sale of securities. These provisions generally prohibit fraudulent, deceptive, or manipulative practices and require issuers, broker-dealers, and advisers to be transparent and honest in their dealings with investors.303 In addition, FINRA rules govern broker-dealer communications with the public— requiring them to reflect fair dealing, good faith, and to be fair and balanced— and prices for securities and services, which must be fair and reasonable given the relevant circumstances. Brokerdealers must also comply with FINRA’s Rules of Fair Practice, which generally require broker-dealers to observe high standards of commercial honor and just and equitable principles of trade in conducting their business. Further, under the Federal securities laws and FINRA rules, prices for securities and broker-dealer compensation are required to be fair and reasonable, taking into consideration all relevant circumstances.304 Under FINRA Rule 2210, brokerdealers’ written (including electronic) communications with the public are subject to obligations pertaining to content, supervision, filing, and recordkeeping. FINRA has also adopted specialized requirements for communications with the public applicable to certain types of investments, including options.305 A 302 See Reg BI Adopting Release, supra note 8, at n.16 and surrounding text. 303 See supra notes 285 and 299. 304 See, e.g., Exchange Act sections 10(b) and 15(c); FINRA Rules 2121 (Fair Prices and Commissions), 2122 (Charges for Services Performed), and 2341 (Investment Company Securities); see also FINRA Rule 3221 (Non-Cash Compensation). 305 See, e.g., FINRA Rule 2211 (Communications with the Public About Variable Life Insurance and PO 00000 Frm 00046 Fmt 4701 Sfmt 4702 broker-dealer’s use of PDA-like technology is subject to these obligations as applicable. In addition, FINRA Rule 2214 provides a limited exception to FINRA Rule 2210’s prohibition on projected performance and allows broker-dealers to use ‘‘investment analysis tools’’ provided certain conditions are met.306 In particular, FINRA Rule 2214 requires broker-dealers using investment analysis tools to describe the criteria and methodology used, including the tool’s limitations and key assumptions.307 Moreover, brokerdealers using investment analysis tools pursuant to the rule must, among other things, describe the universe of investments considered in the analysis, explain how the tool determines which securities to select, and disclose if the tool favors certain securities.308 Broker-dealers are also subject to supervision obligations, including the establishment of policies and procedures and systems for applying such policies and procedures reasonably designed to prevent and detect violations of, and to achieve compliance with, the Federal securities laws and regulations,309 as well as applicable SRO rules.310 Specifically, the Exchange Act authorizes the Commission to sanction a broker-dealer or any associated person that fails to reasonably supervise another person subject to the firm’s or the person’s supervision that commits a violation of the Federal securities laws.311 In addition to broker-dealers’ supervisory obligations under the Exchange Act, FINRA Rule 3110 requires firms to establish and maintain a supervisory system for their business activities and to supervise the activities of their registered representatives, principals and other associated persons for purposes of achieving compliance with applicable securities laws and FINRA Variable Annuities); FINRA Rule 2212 (Use of Investment Companies Rankings in Retail Communications); FINRA Rule 2213 (Requirements for the Use of Bond Mutual Fund Volatility Ratings); FINRA Rule 2215 (Communications with the Public Regarding Security Futures); FINRA Rule 2216 (Communications with the Public About Collateralized Mortgage Obligations (CMOs)); and FINRA Rule 2220 (Options Communications). 306 See FINRA Rule 2214 (Requirements for the Use of Investment Analysis Tools). Investment analysis tools ‘‘are interactive technological tools that produce simulations and statistical analyses that present the likelihood of various investment outcomes if particular investments are made or particular investment strategies or styles are undertaken.’’ FINRA Regulatory Notice 16–41, Communications with the Public (Oct. 2016). 307 See FINRA Rule 2214(c)(1). 308 See FINRA Rule 2214(c)(3). 309 See section 15(b)(4)(E) of the Exchange Act. 310 See FINRA Rule 3110 (Supervision). 311 See section 15(b)(4)(E) of the Exchange Act. E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules D. Benefits and Costs The proposed conflicts rules would impose several requirements on investment advisers and broker-dealers related to conflicts of interest associated with their use of a covered technology in investor interactions. Existing obligations already restrict firms from placing their interests ahead of customers, clients, or investors in certain contexts, such as when providing investment advice or recommendations, including as a result of conflicting interests related to their use of covered technologies. But the proposed conflicts rules would be beneficial because they would apply to a broader set of investor interactions and impose express requirements to evaluate and document certain conflicts of interest and to eliminate them or neutralize their effect. Because advisers and broker-dealers have different regulatory obligations currently, our discussion sometimes addresses the benefits and costs of the proposal to advisers separately from the benefits and costs of the proposal to brokerdealers. For advisers using covered technologies, the proposed rules may represent a shift in their obligations, as firms would be required to take proactive steps to address the conflicts of interest through elimination of conflicts or neutralization of the effect of the conflicts.316 For some technologies, though, advisers may be unable to rely on disclosure to address their existing conflicts obligations to the extent that the complex nature of the technologies and associated conflicts makes it difficult or impossible for the adviser to accurately determine whether it has designed a disclosure to put its clients in a position to be able to understand and provide informed consent to the conflicts; for these technologies, the proposed conflicts rules would specify the steps advisers must take with respect to a conflict of interest associated with the technology, but would not change advisers’ underlying obligation to the extent that full and fair disclosure might be impossible.317 Broker-dealers are governed by, among other requirements, the obligations of Reg BI, which requires that broker-dealers act in the best interest of the customer, when making a recommendation regarding securities to a retail customer. For recommendations, certain conflicts of interest at the firm level can be addressed through disclosure, and others which arise at the level of the firm’s associated persons or resulting from limited menu options can be addressed through mitigation. In addition, under its care obligations, the broker or associated person must have a 312 FINRA Rule 3110(a). In addition, FINRA Rule 3120 requires each member firm to (i) have a system of supervisory control policies and procedures to test and verify that the member’s supervisory procedures are reasonably designed to achieve compliance with applicable securities laws and FINRA rules, and (ii) where necessary, amend or create additional supervisory procedures. 313 FINRA Rule 2241 (Research Analysts and Research Reports). 314 See supra note 212 (citing FINRA Rule 3130(b)). 315 See, e.g., the baseline discussion in Proposed Outsourcing Rule, supra note 124. 316 While full and fair disclosure of all material facts relating to the advisory relationship or of conflicts of interest and/or a client’s informed consent could prevent the presence of those material facts or conflicts themselves from violating the adviser’s fiduciary duty, such disclosure and/ or consent do not themselves satisfy the adviser’s duty to act in the client’s best interest. See Fiduciary Interpretation, supra note 8, at n.58 and accompanying text. 317 An adviser is already obligated to eliminate or mitigate conflicts of interest that cannot be fully and fairly disclosed. See Fiduciary Interpretation, supra note 8. rules. This supervisory system must include, among other things, the establishment, maintenance and enforcement of policies and procedures reasonably designed to achieve compliance with applicable securities laws and regulations and FINRA rules.312 FINRA rules also require policies and procedures to identify and manage conflicts of interest related to research analysts.313 FINRA further requires that the chief executive officer (or equivalent officer) of each member firm must annually certify that it has in place processes which include testing and modifying the firm’s policies and procedures to help ensure that they achieve compliance with applicable laws, regulations, and rules.314 lotter on DSK11XQN23PROD with PROPOSALS2 c. Third-Party Service Providers Currently, third-party service providers who work with investment advisers or broker-dealers may not be required to address or disclose any conflicts of interest that may arise between the firm and the investor when firms use their services. Providers that develop covered technologies for use in the financial sector, however, are likely to be aware of the regulatory requirements governing the use of their products and may alter behavior as a result. Additionally, firms may contractually require service providers to identify potential sources of conflicts to aid firms’ compliance with Commission and SRO rules.315 VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 PO 00000 Frm 00047 Fmt 4701 Sfmt 4702 54005 reasonable basis to believe its recommendations do not place its interests ahead of the retail customer’s interests. However, a broker-dealer has no Regulation BI obligations for nonrecommendation investor interactions, and instead is bound by underlying antifraud provisions and FINRA rules including the Rules of Fair Practice and those governing communications with the public. Firms that have any investor interactions using covered technology would also be required to adopt, implement, and (in the case of brokerdealers) maintain specific policies and procedures with respect to the proposed conflicts rules’ requirements to address conflicts, including with regard to the elimination or neutralization of conflicts of interest that place the firm’s interests ahead of investors’ interests. Firms generally are already required to have policies and procedures with respect to conflicts of interest, which may address conflicts associated with their use of technologies, including technologies that are highly complex and may pose serious risks of conflicts of interest.318 The proposed conflicts rules would provide minimum standards for what such policies must require, and would also seek to ensure all firms using covered technologies in connection with investor interactions.319 By requiring all such firms to have policies and procedures meeting these minimum standards, the proposed conflicts rules would likely represent a shift as compared to the baseline. Many of the investor protection benefits of the proposed conflicts rules would be reduced to the extent that firms are already evaluating and eliminating, or neutralizing the effect of, conflicts associated with the use of covered technology. Benefits could also be reduced to the extent that firms already understand and are able to disclose the potential conflicts of interest associated with covered technology and investors already understand and respond to those disclosures such that disclosure adequately addresses the conflict of interest. On the other hand, for those covered technologies where it is difficult, or impossible, for firms to accurately determine whether they have designed their disclosures to put 318 See Section III.C.3. may include firms that generally meet the proposed requirements already, and, to varying degrees, firms that do not already meet the proposed requirements for a variety of possible reasons including that the firms may not completely understand the covered technology they use or may not recognize conflicts of interest or recognize when disclosure is inadequate. 319 This E:\FR\FM\09AUP2.SGM 09AUP2 54006 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules investors in a position to be able to understand and provide informed consent to conflicts of interest due to the complex nature of the underlying technologies, the proposed conflicts rules could have comparatively greater benefits.320 1. Benefits We preliminarily believe the primary benefit of the proposed conflicts rules and proposed recordkeeping amendments would stem from the requirement to eliminate, or neutralize the effect of, conflicts of interest that place the firm or associated person’s interest ahead of investors’ interests. This requirement could enhance investor protection by eliminating or neutralizing the effects of certain conflicts of interest, particularly in the context of the increasing scope and scale of investor interactions made possible by new technologies and by firms’ increased ability to influence investor behavior in interactions that may not be viewed as constituting a recommendation or investment advice. The evaluation and identification requirements, the policies and procedures requirements, and the recordkeeping requirements primarily support the policy objectives of the elimination and neutralization requirement, and would serve to aid the examinations staff. However, we also note that the evaluation and identification requirements and the policies and procedures requirements might also yield ancillary benefits to investors, which we discuss below. In the following subsections, we discuss the specific requirements of the proposed conflicts rules and proposed recordkeeping amendments in detail. In the first part of this section, we discuss the benefits of the proposed conflicts requirements, and in the second part, we discuss the benefits of the policies and procedures requirements, and in the third, we discuss the benefits of the proposed recordkeeping amendments. lotter on DSK11XQN23PROD with PROPOSALS2 a. Proposed Conflicts Requirements i. Evaluation and Identification The proposed conflicts rules would require that firms evaluate any use or potential use by the firm of a covered technology in any investor interaction, to identify any conflict of interest (including by testing each such covered 320 See, e.g., Bakos, et al., supra note 248; Agnieszka Kitkowska, Johan Ho¨gberg & Erik Wa¨stlund, Online Terms and Conditions: Improving User Engagement, Awareness, and Satisfaction Through UI Design, CHI ’22: Proceedings of the 2022 CHI Conference on Human Factors in Computing Systems, Article No. 624, at 1–22 (Apr. 2022). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 technology prior to its implementation or material modification and periodically thereafter). The terms ‘‘covered technology,’’ ‘‘investor interaction,’’ and ‘‘conflict of interest’’ are defined broadly in the proposal. They would capture a wide variety of technology uses, interactions, and conflicts of interest, not all of which would be required to be eliminated or their effect to be neutralized. However, identifying and evaluating this broad set of activities would help firms to determine which conflicts of interest place a firm’s interests ahead of investors’ interests. This proposed requirement is important to help ensure that firms take proactive steps to identify conflicts of interest and evaluate their nature. Although firms already have obligations to address conflicts of interest, these do not necessarily apply equally to all forms of investor interaction, and the novelty and opacity of some covered technologies may leave firms unaware of conflicts of interest unless they take proactive steps to identify them.321 In addition, the proposed conflicts rules would require firms to test periodically whether any covered technology is associated with a conflict of interest. The test would be required prior to implementation or material modification of the technology, and periodically thereafter. This requirement is important for the proposed conflicts rules because certain technologies might change or adapt over time. For example, algorithms that adapt the firm’s recommendations based on the data it collects from its users might display behaviors that change over time, even though the underlying technology may not have been materially modified, which would need periodic testing to evaluate and to identify any new conflicts of interest that are generated. ii. Determination, Elimination, and Neutralization The proposed conflicts rules would require the firm to determine whether an identified conflict of interest places the interest of the firm or an associated person ahead of the interests of the investor. As discussed below, these types of conflicts may require additional action. Requiring firms to make this determination is critical for the investor protection objectives of the proposed conflicts rules. This requirement would facilitate the elimination and neutralization requirements of the proposed conflicts rules. The proposed conflicts rules would impose requirements on firms to 321 See PO 00000 supra section I.B.4.a. Frm 00048 Fmt 4701 Sfmt 4702 eliminate, or neutralize the effect of, conflicts of interest that place the firm’s or an associated person’s interest ahead of investors’ interests (except for conflicts which exist solely due to seeking to open a new account). As discussed in section III.B, the scale and scope of investor interactions that are now possible with new technologies, and the scope and dynamic nature of the conflicts of interest that can be associated with the use of the technologies, present challenges for the use of disclosure. Disclosure of the full scope and dynamic nature of conflicts of interest that can be associated with the use of covered technologies can potentially be too broad and unspecific to be useful to a particular investor, or alternatively could entail too many disclosures to be useful to an investor. By requiring firms to eliminate, or neutralize, the effect of conflicts of interest that place the firm’s or an associated person’s interest ahead of investors’ interest, the proposed conflicts rules could enhance investor protection and address some of the unique challenges posed by the use of covered technologies in investor interactions. Currently, broker-dealers’ nonrecommendation interactions with investors are not subject to conflict of interest requirements under Reg BI, and are instead bound by underlying antifraud provisions and FINRA rules including the Rules of Fair Practice, the requirement to observe just and equitable principles of trade, and rules governing communications with the public. Given the advances in covered technologies and DEPs, these nonrecommendation interactions have the potential to influence investor behavior and place the firm’s or associated person’s interest ahead of investors’ interests. The use of DEPs in retail investing can exacerbate the principal-agent problem, by influencing investor behavior even if no recommendation is made. These platforms often utilize game-like features such as points, rewards, badges, leaderboards, interactive interfaces, push notifications, and other methods to encourage users to engage in trading activities. Some platforms use PDA technologies to target investors with notifications using detailed datasets, or use social proof and peer influence to influence investor behavior. These practices can take advantage of psychological biases and lead to impulsive, irrational investment decisions. While DEPs are perhaps the clearest and best understood case, behavioral E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules nudges embedded in interfaces, choices about data displays, the responses of chat bots, and other existing or future features may likewise influence investor behavior to their detriment and the benefit of covered firms. These uses of technology in investor interactions make it possible for firms to influence investor behaviors in a way that places the firm’s or associated person’s interest ahead of investors’ interests. The addition of more information through disclosure may not mitigate the negative effects of the use of these DEPs on investing behavior. This is because the use of DEPs can rely on human psychological factors, rather than a lack of information. Given the rate of investor interactions and the ability of technology to learn investor preferences or behavior, disclosures may be too unspecific (if provided to cover the entire relationship) or too frequent (if provided with every interaction) to be useful to investors.322 Moreover, the features and design of covered technologies increase the risk through the constant presence enabled by automation, design practices which encourage habit formation, and the ability to collect data and individually and automatically tailor interventions to the proclivities of each investor. Elimination, or neutralization of the effect of, a conflict of interest could have greater investor protection benefits than disclosure to the extent that it could be difficult for a firm to accurately determine whether it has designed a disclosure that puts investors in a position to be able to understand the conflict of interest despite these psychological factors. Many of the covered investor interactions are already subject to existing requirements described in the baseline. These include the requirements of the investment adviser’s fiduciary duty obligations toward clients; and the broker-dealer’s Conflict of Interest Obligation under Reg BI for recommendation interactions. However, some interactions covered by the proposed conflicts rules would not constitute recommendations for the purposes of Reg BI, and might not receive the same investor protection benefits as recommendations. Relative to the baseline, the proposed conflicts rules would impose requirements specific to the use of covered technologies in investor interactions. The proposed conflicts rules’ conflict of interest obligations would cover the 322 See supra section III.B generally, and supra note 248 on disclosures. See also Reg BI Adopting Release, supra note 8, at III.B.4.c. (discussing the effectiveness and limitations of disclosure). VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 entirety of investment advisers’ interactions with investors, and for broker-dealers the entirety of their interactions with retail investors. This addition is motivated by the complex, opaque, and evolving nature of covered technologies and how firms use them to interact with investors, and the fact that they can operate on psychological rather than rational factors. In this context, for the use of certain complex and opaque technologies, the proposed conflicts rules could enhance investor protection and address some of the unique challenges posed by conflicts of interest in the use of covered technologies in investor interactions. The scope and frequency of investor interactions with new technologies and the complex, dynamic nature of those technologies may make it difficult for investors to understand or contextualize disclosures of conflicts of interest to the extent that the investors interact with the technologies, with interfaces or communications which feature outputs of the technologies, or with associated persons who make use of outputs of the technologies. For example, complex algorithms used in discretionary or nondiscretionary robo-advising platforms could make it difficult for an investor to understand material facts or conflicts of interest and make an informed decision whether to consent or to allocate assets into or out of the platform. This could make it difficult for a firm to accurately determine whether it has designed a disclosure to put investors in a position to be able to understand and provide informed consent to the conflict of interest. Similarly, a chat-bot might provide investment advice based on a set of firm-investor conversations it has been trained to mimic using large language models. This advice may inherit any tendency to act on conflicts already present in conversations with firms or which were introduced by preferentially including conversations in the training data which resulted in the firm deriving greater benefits from the investor’s resulting actions, for instance by overcoming investor resistance. In this situation where a conflict of interest may be exacerbated by the use of a covered technology, eliminating or neutralizing effects that place the firm’s or associated person’s interests ahead of investors’ interests would better protect investors to the extent that investors may be unable to assess, or have difficulty in assessing, the significance of conflicts in the firm’s interactions with them. By eliminating, or neutralizing the effect of, conflicts of interest that place the firm’s or its associated persons’ interest ahead of investors’ interests, the PO 00000 Frm 00049 Fmt 4701 Sfmt 4702 54007 proposed rules would protect investors from the negative effects of these conflicts. As mentioned in Section III.B, these conflicts of interest could lead firms to influence investors to use more services, increase transactions, or invest in risky investments that yield the firm or its associated persons higher profits than other products. To the extent that covered technologies present unique challenges to the current regulatory obligations of firms, eliminating, or neutralizing the effect of these conflicts would benefit investors by protecting them from these behaviors, and enabling them to make investment decisions that are in their best interests and aligned with their investment preferences, or improve the decisions made for the investor on their behalf. The scope and dynamic nature of covered technologies in investor interactions, and the scale at which they can reach investors, can also prompt bandwagon or herding effects in investor behavior that enhance volatility and liquidity risks.323 However, the firms that use covered technologies in investor interactions do not bear all of the costs of these risks. This negative externality creates a suboptimal incentive to allocate resources toward mitigating these risks. The proposed conflicts rules would require identification and evaluation of conflicts of interest, determination of which conflicts of interest place the firm’s or an associated person’s interest ahead of investors’ interests, and elimination, or neutralization of the effect of, these conflicts, which could improve investor confidence in these technologies and prevent the loss of confidence in these technologies from spreading from one firm to another.324 b. Policies and Procedures Under the proposed conflicts rules, any firm that is subject to paragraph (b) of the proposed conflicts rules and that has any investor interactions using covered technology will have policies and procedures obligations. Specifically, investment advisers will be required to adopt and implement written policies and procedures reasonably designed to prevent violation of paragraph (b) of the proposed conflict rule, and broker-dealers will be required to adopt, implement, and maintain 323 GameStop Report, supra note 250. broker-dealers use covered technologies and interact with both retail and non-retail investors. Even though non-retail investors are not defined by the proposed conflicts rule applicable to broker-dealers as investors, they might nevertheless indirectly benefit from the elimination or neutralization of conflicts of interest that place the firm’s interest ahead of investors’ interests. 324 Some E:\FR\FM\09AUP2.SGM 09AUP2 54008 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules written policies and procedures reasonably designed to achieve compliance with paragraph (b) of the proposed conflict rule.325 We do not believe, however, that there is a substantive difference between how firms would need to comply with each proposed conflict rule.326 The written policies and procedures must include the following features: lotter on DSK11XQN23PROD with PROPOSALS2 i. Written Description of Process Evaluating Use, Material Features and Conflicts of Interest of Covered Technology The policies and procedures must include: (i) a written description of the process for evaluating any use or reasonably foreseeable potential use of a covered technology in any investor interaction pursuant to paragraph (b) and (ii) a written description of any material features of, including any conflicts of interest associated with the use of, any covered technology used in any investor interaction prior to such covered technology’s implementation or material modification, which must be updated periodically. These written policies and procedures help to ensure firms adopt effective implementation plans and help examinations staff assess whether firms have complied with paragraph (b) of the proposed conflicts rules. Requiring that firms describe the process they use to evaluate the use or potential use of covered technologies is important for helping ensure that firms understand and document how their technology will be used or potentially used, and whether it involves investor interaction. Similarly, requiring a description of the material features of, and any conflicts of interest associated with the use of, the covered technology is important for helping ensure firms understand and document how their technology functions, and the conflicts of interest associated with their use. Requiring that the description of material features and conflicts of interest be in place before implementation or material modification would help ensure that firms consider covered technologies and identify and address conflicts of interest before investors could be harmed. In addition, these written descriptions would be required to be updated periodically. Given that the effects of technologies can change materially as they are further developed or used in new contexts, this requirement would help ensure that the information remains current and the firm performs 325 See 326 See supra note 196. id. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 the necessary evaluation before harmful changes can proliferate. ii. Written Description Determining Whether and How To Eliminate, or Neutralize the Effect of, Any Conflict of Interest The proposed conflicts rules would require that the policies and procedures include a written description of the process for determining whether and how to eliminate, or neutralize the effect of, any conflicts of interest determined pursuant to paragraph (b)(2) of the proposed conflicts rules to place the interest of the firm or an associated person ahead of the interests of the investor. The proposed conflicts rules give firms considerable latitude to determine how to approach the elimination, or neutralization of the effect of, conflicts of interest. While this is necessary to help the proposed conflicts rules apply to a wide variety of business models and technologies, it also raises the risk that firms could adopt approaches that are inadequate to prevent them from placing their interests ahead of those of investors. This requirement would promote the development of considered and documented policies and procedures for determining whether and how to eliminate, or neutralize the effect of, any conflict of interest, instead of doing so on an ad hoc basis. Having a documented policy and procedure could also aid the training of the firm’s compliance staff, and aid examiners and the firm when assessing a firm’s compliance with the rules. iii. Review of Written Description The proposed conflicts rules would also require that the policies and procedures include a review of the written description required pursuant to paragraph (c)(1) of the proposed conflicts rules. The periodic review element requires a firm to consider whether any changes in the business activities, any changes in the use of technology generally, any issues that arose with the technologies during the previous year, and any changes in applicable law might suggest that certain covered technologies are of a different or greater risk than the firm had previously understood. Based on this periodic review, firms might be better able to determine whether changes are necessary in their approach to identification, determination, and elimination or neutralization of conflicts of interest and whether material changes to the use of technology are reflected by the written description. The regular review of the written description can help to ensure that the investor PO 00000 Frm 00050 Fmt 4701 Sfmt 4702 protection benefits of the proposed rules do not diminish after a covered technology is initially implemented, and improve investor confidence that firms have updated policies and procedures to identify, determine, and eliminate or neutralize certain conflicts of interest. c. Proposed Recordkeeping Amendments The proposed recordkeeping amendments would require firms to make and keep several types of records. First, firms would be required to maintain written documentation of the evaluation conducted pursuant to paragraph (b)(1) of the proposed conflicts rules, including a list or other record of all covered technologies used by the firm in investor interactions, as well as documentation describing any testing of the covered technology in accordance with paragraph (b)(1) of the proposed conflicts rules. Second, firms would be required to maintain written documentation of each determination made pursuant to paragraph (b)(2) of the proposed conflicts rules, including the rationale for such determination. Third, firms would be required to maintain written documentation of each elimination or neutralization made pursuant to paragraph (b)(3) of the proposed conflicts rules. Fourth, firms would be required to maintain written policies and procedures, including written descriptions, prepared in accordance with paragraph (c) of the proposed conflicts rules. Fifth, firms would be required to maintain a record of the disclosures provided to investors regarding the firm’s use of covered technologies. And sixth, firms would be required to maintain records of each instance in which a covered technology was altered, overridden, or disabled, the reason for such action, and the date thereof, including records of all instances where an investor requested that a covered technology be altered or restricted in any manner. The proposed recordkeeping amendments would help ensure that a record of a firm’s use of covered technology is maintained and preserved for an appropriate period of time consistent with the firm’s other existing recordkeeping obligations. The proposed recordkeeping amendments would also help facilitate the Commission’s oversight and enforcement capabilities by creating a record that the staff could use to assess compliance with the requirements of the proposed conflicts rules, and help ensure that the investor protection benefits of the proposed rules are realized. E:\FR\FM\09AUP2.SGM 09AUP2 54009 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules 2. Costs This section discusses two types of costs. We discuss the direct costs of the requirements of the proposed conflicts rules and proposed recordkeeping amendments and provide quantitative estimates of the costs of each provision. We then discuss the indirect costs of the proposed conflicts rules and proposed recordkeeping amendments, such as the potential impact on the use of technology and innovation. a. Direct Costs i. Proposed Conflicts Rules—Eliminate, or Neutralize the Effect of, Conflicts of Interest We preliminarily anticipate that firms might need to hire dedicated personnel or dedicate the time of existing personnel to comply with the requirements of the proposed conflicts rules. The cost of identifying the presence of conflicts present in technology and determining if they lead to interactions in which the interests of the firm are placed ahead of those of the investor may vary greatly. Firms which have more conflicts of interest, or have conflicts more deeply embedded in the covered technologies they use, would likely bear greater costs than those that do not. Similarly, a firm’s costs are likely to vary depending on the nature of covered technology they use in investor interactions and the extent of that use. For tools and processes which are relatively transparent, a code review may suffice. For technology where the process of generating outputs from a given set of inputs is opaque, as is often the case with the product of machine learning, it may be necessary to develop a testing system or engage with an independent third party with a system to identify conflicts of interest in all reasonably foreseeable uses of the technology. Such a system might record the outputs of the technology, measure the prospective or achieved outcomes for the investor and the firm, and compare them to those achieved by alternative specifications of the technology. To the extent that training models often require substantial computational resources and human feedback during the training process, testing of opaque systems could entail significant costs, which could entail the need to either hire dedicated personnel, or allocate the time of existing personnel. The direct costs to eliminate, or neutralize the effect of, conflicts of interest in covered technologies would depend strongly on the technology used, the firm’s business model, the nature of the conflicts, and the nature and extent of the interactions. For traditional optimizing methods or functions where a conflict is explicitly included in the model, the cost of excising the offending features may be trivial. In contrast, for methods which are opaque or where the technology optimizes over factors other than the firm’s or an associated person’s interest, but which may correlate with the firm’s or associated person’s interest, a more substantial and thus costly testing regime might be necessary. For some methods, such as NLP methods trained to replicate employee responses to investor communications, additional human input into the training process may be necessary to identify responses which potentially reflect conflicts of interest. This training input could be substantial and may need to be repeated as market institutions and conditions change, particularly if such changes are such that the data set on which the technology was trained does not adequately reflect new conditions. In some cases, firms could opt to eliminate conflicts directly, such as by changing their fee structure or other revenue generation models, rather than eliminating or neutralizing the consideration of the conflicts within their covered technologies. We provide two sets of cost estimates in Table 1, to reflect the extent to which the costs can vary depending on the complexity of the firm’s use of covered technology. Firms with complex covered technologies, such as machine learning or NLP algorithms, or those that process large datasets, might require more resources to comply with the requirements associated with eliminating, or neutralizing the effect of, conflicts of interest where the firm’s or an associated person’s interest is placed ahead of the interests of investors. Firms with simple technologies, such as spreadsheets or basic algorithms, would likely require fewer resources. In addition, firms might have business models of varying complexity, or with varying degrees of investor interaction, which could affect the costs they would bear. The Commission seeks comment or data on the costs of requirements of the proposed rules that could improve these estimates. TABLE 2—DIRECT COSTS OF PROPOSED RULES REQUIREMENTS TO EVALUATE, IDENTIFY, DETERMINE, AND ELIMINATE, OR NEUTRALIZE THE EFFECT OF, CERTAIN CONFLICTS OF INTEREST Simple covered technology firm Proposed rules requirement Initial hours Initial cost Evaluate Use of Covered Technology and Identify Conflicts of Interest ........................... Determine Which Conflicts of Interest Require Elimination or Neutralization .......................... Eliminate or Neutralize Effects of Certain Conflicts of Interest .............................................. 10 Sub-Total Burden ....................................... 25 Complex covered technology firm Annual cost Initial hours Initial cost Annual cost $4,460 5 $2,230 100 $44,600 50 $22,300 5 2,230 2.5 1,115 50 22,300 25 11,150 4,460 5 2,230 200 89,200 100 44,600 11,150 12.5 5,575 350 156,100 175 78,050 314,650 140,333,900 16,182 404,550 180,429,300 1,798 202,275 90,214,650 629,300 280,667,800 1 Commission lotter on DSK11XQN23PROD with PROPOSALS2 Annual hours 10 Total Number of Firms ...................................... Total Aggregate Burden ............................. Annual hours staff estimates, based on blended rate for a senior portfolio manager ($383), senior operations manager ($425), compliance attorney ($425), assistant general counsel ($523), senior programmer ($386), and computer operations department manager ($513), rounded to the nearest dollar. 2 Based on the estimates in section IV.B, we preliminarily estimate that 17,719 firms will bear the cost of a Simple Covered Technology firm, consisting of 15,402 investment advisers and 2,317 broker-dealers. We preliminarily estimate that 1,798 firms will bear the cost of Complex Covered Technology firm, consisting of 1,540 investment advisers and 258 broker-dealers. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 PO 00000 Frm 00051 Fmt 4701 Sfmt 4702 E:\FR\FM\09AUP2.SGM 09AUP2 54010 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 ii. Proposed Conflicts Rules—Policies and Procedures The policies and procedures portion of the proposed conflicts rules would require investment advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of paragraph (b) of the proposed conflicts rules, and brokerdealers to adopt, implement, and maintain written policies and procedures reasonably designed to achieve compliance with paragraph (b) of the proposed conflicts rules.327 These policies and procedures would need to include a written description of any material features of, any conflicts of interest associated with the use of, and any covered technology used in any investor interaction prior to such covered technology’s implementation or material modification. In addition, the policies and procedures must require that the adequacy of the policies and procedures and written description of material features be reviewed regularly. The policies and procedures also must require a written description of the process by which the firm determines whether and how to eliminate, or neutralize the effect of, any conflicts of interest determined pursuant to paragraph (b)(2) of the proposed rules to place the interest of the firm or an associated person ahead of the interests of the investor. We note that the Commission has provided certain estimates for purposes of compliance with the Paperwork Reduction Act of 1995 (‘‘PRA’’), as further discussed in Section IV below. Those estimates, while useful to understanding the collection of information burden associated with the final rules, do not purport to reflect the full economic costs associated with making the required disclosures. The PRA cost estimates are: (1) for the adoption and implementation of policies and procedures, an annual cost of $14,610 for the firm; (2) for the requirement to create and maintain a written description of the covered technology, an annual cost of $18,955 on firms and (3) and for the annual review requirement, an ongoing annual cost of $2,230.328 iii. Proposed Recordkeeping Amendments As discussed above, the proposed recordkeeping amendments would require firms to maintain information about the firm’s use of covered technology in investor interactions, and any associated conflicts of interest. This 327 See 328 See supra note 196. infra section IV.B. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 includes written documentation of the evaluation conducted pursuant to paragraph (b)(1) of the proposed conflicts rules, including a list or other record of all covered technologies used by the firm in investor interactions, as well as documentation describing any testing of the covered technology in accordance with paragraph (b)(1) of the proposed conflicts rules; written documentation of each determination made pursuant to paragraph (b)(2) of the proposed conflicts rules, including the rationale for such determination; written documentation of each elimination or neutralization made pursuant to paragraph (b)(3) of the proposed conflicts rules; written policies and procedures, including written descriptions, prepared in accordance with paragraph (c) of the proposed conflicts rules; a record of the disclosures provided to investors regarding the firm’s use of covered technologies; and records of each instance in which a covered technology was altered, overridden, or disabled, the reason for such action, and the date thereof, as well as records of all instances where an investor requested that a covered technology be altered or restricted in any manner. While these requirements aid the Commission in assessing the extent to which firms have complied with the other requirements of the proposed conflicts rules, we expect these requirements to impose costs on firms that will have to create and maintain these records. As further discussed in Section IV below, the PRA estimates that firms would face an ongoing annual cost of $7,622 from the recordkeeping requirements, but would not face initial costs. b. Indirect Costs In the previous section, we discussed the direct costs of complying with the requirements of the proposed conflicts rules and proposed recordkeeping amendments. However, firms might not bear the ultimate burden of these costs. Firms might pass the cost of the requirements along to investors through higher fees, commissions, or other methods. It is difficult to estimate or quantify how much of these costs firms will end up paying themselves instead of passing on to investors, and this depends on how sensitive investors are to changes in the cost of the service provided by the firm, and how sensitive the firm is to changes in the costs of providing that service.329 329 Arnold C. Harberger, The Incidence of the Corporation Income Tax, 70 J. Pol. Econ. 215–240 (1962). The ultimate cost burden will be determined by the relative elasticity of the demand and supply PO 00000 Frm 00052 Fmt 4701 Sfmt 4702 The proposed requirements to eliminate, or neutralize the effect of, conflicts of interest which place the firm’s or an associated person’s interest ahead of the interests of investors can impose additional costs on the firm. Eliminating conflicts or neutralizing their effect can cause firms to lose the revenue that might have been generated by conflicts associated with uses of the technology, where the firm complied with and made adequate disclosure under all preexisting rules regarding conflicts of interest. In addition, eliminating conflicts or neutralizing their effect could also make technologies less efficient, as firms might alter these technologies with internal checks and safeguards to comply with the rules. For example, firms might add testing code to the technology or guard rails to the development process that could make the technology or its development less efficient and impose costs on the firm. The overall costs, including recordkeeping costs, of the proposed conflicts rules and proposed recordkeeping amendments could also cause some firms to avoid using certain covered technologies in investor interactions, even if the technologies did not create any conflicts of interest. This might happen if the costs of complying with the proposed rules and amendments exceed the revenue that can be gained and/or costs that can be saved by using the technology. For example, a firm might opt not to use an automated investment advice technology because of the costs associated with complying with the proposed rules and amendments. In these types of situations, firms would lose the potential revenues that these technologies could have generated, and investors would lose the potential benefits of the use of these technologies. In addition, in the absence of these technologies, firms might raise the costs of their services, thus increasing the costs to investors. In addition, to the extent that the firm’s existing obligations do not require the elimination, neutralization, or disclosure of covered conflicts of interest, the requirement to identify conflicts of interest in a technology could dissuade firms from using certain technologies when it is too difficult or costly to adequately evaluate the use of the covered technology, identify a conflict of interest, or determine whether they place the firm’s or an curves for the service provided by the technology. Although this paper refers to the incidence of the tax burden, it is mechanically identical to determining which entities will bear the ultimate cost of the proposed rules. E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules associated person’s interest ahead of an investor’s. Some types of AI and machine learning, or a marketing algorithm with a large dataset, could be costly to test or difficult for the firm to assess. In these situations, investors would lose the potential benefit of these types of technologies, which could in theory have no conflict of interest, but firms might have no practical or financially viable way to demonstrate that there was not a conflict of interest or that any such conflict did not result in actions placing the firm’s or an associated person’s interest ahead of an investor’s interest. Similarly, there may be technologies that do create conflicts that must be eliminated or their effect neutralized, but that also benefit investors if firms address those conflicts. Investors would lose the benefit of such technologies if firms determine that the process of eliminating, or neutralizing the effect of, conflicts is too difficult, costly, or uncertain to succeed. Broker-dealers that use covered technologies and interact with both retail and non-retail investors might pass along some of the cost burden of the rules onto both retail and non-retail investors. Even though non-retail investors are not defined by the proposed rules as investors, they might nevertheless indirectly bear some of the costs of the proposed conflicts rule. In addition, non-retail investors might also be adversely affected to the extent that broker-dealers alter the use of their covered technologies to respond to conflicts of interest with retail investors. We anticipate that firms may rely on third-party providers to develop covered technologies. Even if these third-party providers are not regulated entities under the proposed conflicts rules, they could consider the proposed rules when designing their products and processes for firms that must meet the proposed conflicts rules’ requirements, either independently or at the request of firms covered by the proposed conflicts rules. To the extent that the requirements of the proposed conflicts rules result in more costly development, testing, and documentation, these third-party providers may incur costs. In addition, competition between third-party providers might drive down the costs of compliance for firms. Firms with bargaining power might also seek to pass on certain compliance costs to third-party providers, for instance by seeking assurances that the covered technology provided by the third party would not generate conflicts of interest between the firm and the investor. In this context, competition between thirdparty providers might pass some or all VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 of these costs on to firms in product prices and service fees, and firms in turn may pass some or all of these costs on to investors. The proportion of costs that are passed through each entity will depend on competition among providers and firms, the price sensitivity of investors, and the perceived value of the various covered technologies. The requirements to test and document conflicts related to the use of technologies would not only add costs to firms that use covered technologies in investor interaction, they could also slow down the rate at which firms update existing or develop or adopt new technologies. The time needed to review and document changes to the technology could incentivize firms to reduce the frequency of technological updates, or slow the overall rate of updates, which could harm both the firm and investors. These delays and associated monetary costs could reduce the quality or increase the cost of the technology or service for investors, and could reduce the revenues of the firms. E. Effects on Efficiency, Competition, and Capital Formation 1. Efficiency The proposed conflicts rules would positively impact efficiency by providing investors with greater confidence regarding the conflicts of interest associated with the use of covered technologies that they interact with or whose outputs help determine the form or content of investor interactions. Investors would not have to expend costly efforts (including in terms of the opportunity cost of time) on understanding the effects of complex and opaque technologies, and the disclosures thereof, that the firms use in their interactions with investors when they can instead rely on conflicts which place the interest of the firm or an associated person ahead of investors’ interests to have been eliminated or their effect to have been neutralized. Further, myriad of investors would not have to duplicate these costly efforts that they each may otherwise independently expend. In this context, the proposed conflicts rules would enhance economic efficiency by improving the efficiency of portfolio allocations, or by enabling the resources thereby saved to be allocated to more productive economic outcomes. In addition, reducing the costly effort that investors must undertake to understand covered technologies and their associated disclosures by eliminating, or neutralizing the effect of, conflicts of interest that place the firm’s or an PO 00000 Frm 00053 Fmt 4701 Sfmt 4702 54011 associated person’s interest ahead of an investor’s could increase participation in financial markets and improve efficiency. The proposed conflicts rules could negatively affect efficiency by impeding the use of technology in several ways. First, the compliance costs of the proposed conflicts rules could dissuade some firms from using covered technologies in investor interactions. For example, a firm might decide that using a chatbot technology that provided investment advice would be too costly because of the obligations imposed by these rules, and instead opt for human alternatives. To the extent that the chatbot technology was more efficient at providing support to investors, the efficiency of the firm’s ability to provide advice would be decreased. Second, certain types of technology might be too difficult or costly to evaluate, or to modify to comply with the rules, and firms could avoid using these technologies. For example, a firm might decide that a covered technology was developed based on data that are too complex to evaluate, or to identify all conflicts of interest, and therefore the firm might have difficulty complying with the proposed conflicts rules. In these cases, firms and investors would not enjoy any of the efficiency gains that the covered technology might have yielded, or have yielded if already implemented. Third, the costs and requirements could slow down the frequency or overall rate of technological updates to existing covered technologies and exploration of new covered technologies, as well as make the technology itself less efficient. For example, firms might need to add guard rails to the development process, or additional layers of review of any potential changes to the technology. Not only could this harm the firm and investors due to, for example, foregone cost savings, lack of tailoring of recommendations to individual investors, or unimplemented user experience improvements, but it also could slow down technological innovation and progress more broadly.330 However, to the extent rapid development and implementation of such innovations result in the release of flawed or otherwise harmful products into the marketplace, efficiency may be improved.331 330 These losses in efficiency could also adversely affect non-retail investors that interact with brokerdealer covered technologies that also interact with retail investors. 331 We do not expect the proposed recordkeeping amendments to generate significant effects on efficiency. The proposed recordkeeping E:\FR\FM\09AUP2.SGM Continued 09AUP2 54012 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 2. Competition Eliminating, or neutralizing the effect of, conflicts of interest would have two principal competition-related effects. First, investors could have greater confidence in interactions with firms using covered technologies, and could therefore be more likely to participate in financial markets. Second, when evaluating firms, investors would likely put additional weight on key factors such as advisory, management, or brokerage fees and execution quality, which also directly impact market efficiency, thereby increasing the extent to which firms compete on these factors. These two effects could positively affect competition between firms and result in lower fees and higher service quality for investors. The proposed conflicts rules could also result in costs that could act as barriers to entry or create economies of scale, potentially making it challenging for smaller firms to compete with larger firms utilizing covered technologies—as firms continue to increasingly rely on covered technologies for investor interactions.332 Ensuring compliance with the proposed conflicts rules would require additional resources and expertise, which could become a significant barrier to entry, potentially hindering smaller firms from entering the market or adopting new technologies. Moreover, larger firms with a larger client or customer base may have a competitive advantage over smaller firms because they may be better able to spread the (fixed) cost of the proposed conflicts rules across their clients, or more effectively negotiate with third party providers to obtain compliant technology externally. Smaller firms subject to the proposed conflicts rules could also face a competitive disadvantage compared to larger firms when negotiating with technology companies to build software that complies with the proposed conflicts rules. These competitive effects might be mitigated to the extent that firms are using technologies licensed from third party providers. Third party technology providers might compete with each other to lower the cost of compliance, compared to the case where firms bore the costs of compliance internally. Moreover, to the extent that firms have amendments generally would serve to support the implementation of the proposed conflicts rules. 332 Similarly, some broker-dealers with a small retail investor business line and a larger non-retail investor business line could decide to cut back on serving retail investors to avoid incurring the compliance costs. This could increase market concentration among broker-dealers that service retail investors. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 bargaining power over third party providers, they may be able to shift some of the compliance burden onto these providers. To the extent that third party providers develop the ability to lower compliance costs through competition, smaller firms may also experience reduced compliance costs.333 3. Capital Formation The impact of the proposed conflicts rules on capital formation would be influenced by a number of factors. On the one hand, the elimination or neutralization of the effects of certain harmful conflicts of interest in firms’ use of covered technologies could enhance capital formation if the quality of services is improved, or investment performance or execution quality is improved, and investors trust these technologies more and invest more as a result. On the other hand, the costs associated with the proposed conflicts rules could have the opposite effect. If these costs result in increased fees for investors or deter firms from using covered technologies in investor interaction, then capital formation could be hindered. This could be particularly problematic for smaller firms who may struggle to absorb these additional costs. In addition, to the extent that the costs of the technology are too high and firms avoid using certain covered technologies that benefit investors, capital formation could be hindered.334 F. Reasonable Alternatives In formulating our proposal, we have considered various alternatives. Those alternatives are discussed below and we have also requested comments on certain of these alternatives. 1. Expressly Permit, or Require, the Use of Independent Third-Party Analyses This alternative would expressly state that firms may utilize independent third parties to assess compliance with elements of the proposed conflicts rules.335 A variation on this alternative would require the use of independent third-party assessments. Allowing or requiring the use of independent third parties to carry out and assess compliance could help ensure that 333 We do not expect the proposed recordkeeping amendments to generate significant effects on competition. The proposed recordkeeping amendments generally would serve to support the implementation of the proposed conflicts rules. 334 We do not expect the proposed recordkeeping amendments to generate significant effects on capital formation. The proposed recordkeeping amendments generally serve to support the implementation of the proposed conflicts rules. 335 The proposed conflicts rules do not prohibit such third-party analyses. PO 00000 Frm 00054 Fmt 4701 Sfmt 4702 identification and evaluation of conflicts of interest, the determination of which conflicts of interest place the firm’s or an associated person’s interest ahead of investors’, and the elimination, or neutralization of the effect of, the conflict of interest are done in an objective and unbiased manner. In addition, the use of independent third parties could reduce the costs of complying with the associated proposed conflicts rules and eliminate or reduce the need for firms to maintain dedicated staff. Independent third-party firms might have more expertise or be more efficient than individual firms, especially smaller firms, at analyzing the function and the effects of covered technologies, especially technologies licensed from third party service providers. However, this alternative could undermine the investor protection benefits of the proposed conflicts rules and proposed recordkeeping amendments if independent third parties are less efficient at identifying and evaluating conflicts of interest in the use of covered technologies in investor interactions, because they might not have the same level of information about a firm’s business and investors. In addition, competition between independent third parties for the business of firms could result in a ‘‘race to the bottom’’ of the quality of compliance assessments. 2. Require That Senior Firm Personnel and/or Specific Technology SubjectMatter Experts Participate in the Process of Adopting and Implementing These Policies and Procedures This alternative would add a requirement to the proposed conflicts rules that senior firm personnel and/or specific technology subject-matter experts participate in the process of adopting and implementing these policies and procedures. In addition, these senior firm personnel and/or specific technology subject-matter experts would be required to certify that such policies and procedures that the firm adopts and implements (and, in the case of broker-dealers, maintains) are in compliance with the requirements of this paragraph (c) of the proposed conflicts rules. Requiring the use of these personnel could potentially enhance the effectiveness of the policies and procedures that firms create, which could improve a firm’s ability to evaluate and identify conflicts of interest, and eliminate or neutralize conflicts of interest that place the firm’s interest ahead of the investors. To the extent that such personnel are not necessary to satisfy the policies and E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules procedures requirements of the proposed conflicts rules, the requirement to use these personnel could impose additional costs on firms, which would have to hire additional personnel to satisfy the requirement, divert the labor of existing personnel, or engage with a third-party service provider. In addition, the requirement that these personnel provide a certification for the policies and procedures would also add additional costs not present in the proposal on firm, and create potential barriers to entry for small firms. lotter on DSK11XQN23PROD with PROPOSALS2 3. Provide an Exclusion for Technologies That Consider Large Datasets Where Firms Have No Reason To Believe the Dataset Favors the Interests of the Firm From the Identification, Evaluation, and Testing Requirements This alternative would provide an exclusion from all of the proposed requirements for technologies that consider large datasets, where firms have no reason to believe the dataset favors the interests of the firm. An example of this type of technology might include a chatbot technology that is trained on large portions of the internet. To the extent that the training dataset is not chosen or created in a biased manner, a firm could reasonably believe that it does not consider the interest of the firm, and yet the firm could have difficulty complying with the proposed conflicts rules’ requirements to identify conflicts of interest generated by the use of the technology. An exclusion for this type of technology use could reduce the costs imposed on the firms that use these technologies, or make certain covered technologies cost-effective to use. However, the exclusion could also undermine the investor protection goals of the proposed conflicts rules by lowering the standards placed on firms’ use of covered technologies in investor interactions. Even though firms likely would need to conduct due diligence in order to establish their reasonable belief, and update it regularly, this alternative could result in a regime where firms only reasonably believe that their technologies do not have conflicts of interest, rather than one where firms have tested for conflicts of interest in their covered technologies. In addition, this alternative may incentivize firms to avoid testing datasets in order to avoid receiving information that would challenge their reasonable belief about the unbiased nature of their data. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 4. Apply the Requirements of the Proposed Conflicts Rule and Proposed Recordkeeping Amendments Only to Broker-Dealer Use of Covered Technologies That Have NonRecommendation Investor Interaction This alternative would limit the scope of the requirements to covered technologies used by broker-dealers in non-recommendation interactions with investors. Such an alternative would target those investor interactions that fall outside Reg BI’s Conflict of Interest Obligation. These broker-dealer nonrecommendation interactions can influence investor behavior due to advances in technology and the psychological biases of investors. Imposing requirements on broker-dealer covered technologies that have nonrecommendation interactions with investors would expand the set of investor interactions that have some form of conflict of interest obligation, requiring that broker-dealers eliminate, or neutralize the effect of, certain conflicts of interest that arise in nonrecommendation interactions covered by the proposed conflicts rule. This alternative would also place on certain non-recommendation interactions the proposed policies and procedures and recordkeeping obligations, including those related to testing. However, this alternative cedes the benefits and costs of the proposed conflicts rules’ requirements for a large portion of investor interactions with covered technologies, namely those interactions with broker-dealers that involve a recommendation, and with investment advisers. These interactions would still be subject to existing conflict of interest obligations, but would not benefit from, for example, the proposed evaluation and identification (including testing) provisions or the requirement to eliminate, or neutralize the effects of, conflicts of interest that place the firm’s or an associated person’s interest ahead of investors’ interests. In addition to forgoing these benefits, this alternative would result in non-recommendation interactions being subject to more prescriptive requirements, and more documentation pursuant to the policies and procedures and recordkeeping elements of the proposal, than recommendation interactions, which could create frictions for broker-dealers that use covered technologies that have both recommendation and nonrecommendation interactions with investors. Another variation of this alternative would, in addition to the application of the requirements of the proposed conflicts rules to broker-dealer use of PO 00000 Frm 00055 Fmt 4701 Sfmt 4702 54013 covered technology for nonrecommendation investor interactions, apply the policy and procedures requirements and the recordkeeping requirements of the proposed conflicts rules and proposed recordkeeping amendments to investment adviser and broker-dealer use of covered technology with any investor interaction. This alternative would forgo the benefits and costs associated with the proposal’s requirement to eliminate, or neutralize the effect of, certain conflicts of interest for advice and recommendation interactions. However, the alternative might strengthen existing conflict of interest obligations by requiring that firms have documented policies and procedures to evaluate the use of covered technologies, the conflicts of interest associated with their use, and the extent to which any conflicts of interest place the firm’s interest ahead of the investors, which could yield investor protection benefits for investors. This alternative would impose the costs of the policies and procedures requirements and the recordkeeping requirements on firms. 5. Require That Firms Test Covered Technologies on an Annual Basis, or at a Specific Minimum Frequency This alternative would require that firms test covered technologies used in investor interactions on an annual basis at a minimum, instead of periodically as under the proposal. This alternative could enhance investor protection by ensuring that covered technologies used in investor interactions are tested regularly at a minimum level for conflicts of interest. However, this alternative could impose unnecessary costs on firms that use covered technologies which have relatively static potential for conflicts of interest. For example, an investment recommendation algorithm that bases its responses on a static data set and accepts limited input from investors from a simple questionnaire, might not need to be tested as frequently as push notifications based on a dataset that is frequently being updated. Similarly, a covered technology operating within a static business model or defined set of investor interactions might not need to be tested as frequently. Imposing a minimum testing frequency that would be adequate for the latter example would impose unnecessary costs on the former, and a minimum testing frequency that would be suitable for the former example might be too infrequent for the latter example, potentially exposing investors to unidentified conflicts of interest. E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 54014 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules 6. Require That Firms Provide a Prescribed and Standardized Disclosure This alternative would require that firms deliver to investors prescribed and standardized disclosure of conflicts of interest that place the firm’s or an associated person’s interest ahead of investors’ interests, in lieu of the proposed conflicts rules’ requirement to eliminate, or neutralize the effect of, such conflicts of interest.336 Firms would also have to file their disclosures with the Commission. This disclosure would be a free-standing form like Form CRS, but would focus on the conflicts of interest associated with covered technologies and their use in investor interactions. The prescribed and standardized disclosure would require information such as the technologies used, a brief description of how they work, the data used, any third-party service providers associated with the technology, and any conflicts of interest identified. This disclosure would be in addition to the firm’s existing Reg BI, fiduciary duty, and other baseline disclosure obligations. By providing a prescribed and standardized disclosure, the firm could address the effects of the conflicts of interest by providing additional information and context in a format that is more easily understood by investors. A prescribed and standardized disclosure could also reduce the costs to investors to understand and interpret information about covered technologies. In addition, these disclosures might allow investors to more easily compare the conflicts of interest that firms have, or understand which firms use the same or similar underlying covered technologies. However, it is not clear that prescribing a standardized disclosure would be sufficient to enable investors to provide informed consent or otherwise achieve the investor protection goals of the proposed rules. In particular, disclosure may be ineffective in light of, as discussed in section III.B, the rate of investor interactions and the ability of the technology to learn investor preferences or behavior, which could entail providing disclosure that is highly technical and variable. Firms might have difficulty fully conveying the scope of conflicts of interest generated by the use of covered technologies, which could hamper its ability to address the effects of conflicts of 336 However, the use of covered technology in investor interaction would still be subject to the firm’s existing conflict of interest obligations, which might require the firm to eliminate or mitigate the conflict of interest. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 interest they generate. And, as previously discussed, disclosures may be too lengthy to be meaningful or actionable.337 Conflicts disclosure may also, for example, lead to under- or overreaction by investors: investors may not know how to respond to information about conflicts and therefore fail to adequately adjust their behavior, or may overreact to disclosures of conflicts of interest and therefore forgo valuable investment advice.338 G. Request for Comment We request comment on all aspects of the economic analysis of the proposed conflicts rules and proposed recordkeeping amendments. To the extent possible, we request that commenters provide supporting data and analysis with respect to the benefits, costs, and effects on competition, efficiency, and capital formation of adopting the proposed conflicts rules and proposed recordkeeping amendments or any reasonable alternatives. In particular, we ask commenters to consider the following questions: 94. What additional regulatory, qualitative, or quantitative information should be considered as part of the baseline for the economic analysis of the proposed conflicts rules and proposed recordkeeping amendments? 95. The Commission seeks comment on the types of technologies that are currently in use that could potentially be affected by the proposed conflicts rules and proposed recordkeeping amendments. Have they been accurately characterized? If not, why not? Are there any technologies that haven’t been included, that should be? Are there any technologies that have been included, that shouldn’t be? Is the simpler and complex technology distinction discussed in this release sufficient to 337 See supra note 248 and surrounding text. e.g., James M. Lacko & Janis K. Pappalardo, The Effect of Mortgage Broker Compensation Disclosures on Consumers and Competition: A Controlled Experiment, Federal Trade Commission, Bureau of Economics Staff Report (Feb. 2004), https://www.ftc.gov/sites/ default/files/documents/reports/effect-mortgagebroker-compensation-disclosures-consumers-andcompetition-controlled-experiment/ 030123mortgagefullrpt.pdf (documenting that when mortgage customers receive information about mortgage broker compensation through disclosures, such disclosures lead to an increase in more expensive loans and create a bias against brokersold loans, even when the broker-sold loans are the more cost effective option); George Loewenstein, Cass R. Sunstein, & Russell Golman, Disclosure: Psychology Changes Everything, 6 Ann. Rev. Econ. 391 (2014). See also Reg BI Adopting Release, supra note 8, at III.B.4.c. (discussing the effectiveness and limitations of disclosure). See also SEC Staff Study Regarding Financial Literacy Among Investors, August 2012, at https://www.sec.gov/news/studies/ 2012/917-financial-literacy-study-part1.pdf. 338 See, PO 00000 Frm 00056 Fmt 4701 Sfmt 4702 describe the cost burdens of technologies? 96. The Commission seeks comment on the conflicts of interest associated with the use of covered technologies. What types of conflicts of interest are associated with the use of these technologies? What costs do they impose on investors? What practices exist for eliminating, or neutralizing the effect of, these conflicts of interest? What practices exist for mitigating the effects of these conflicts of interest? What are the current costs of these methods? 97. Are the costs and benefits of the proposed conflicts rules and proposed recordkeeping amendments accurately characterized? If not, why not? Should any of the costs or benefits be modified? What, if any, other costs or benefits should be taken into account? If possible, please offer ways of estimating these costs and benefits. What additional considerations can be used to estimate the costs and benefits of the proposed conflicts rules and proposed recordkeeping amendments? 98. Are the effects on competition, efficiency, and capital formation arising from the proposed conflicts rules and proposed recordkeeping amendments accurately characterized? If not, why not? 99. The Commission seeks comment on the potential costs associated with the proposed conflicts rules and proposed recordkeeping amendments. What types of costs are likely to be incurred by firms in order to comply with the proposed conflicts rules and proposed recordkeeping amendments? How might these costs vary depending on the types of technology, the business model, or the nature and extent of investor interactions used by the firms? To what extent do firms already incur these costs in order to comply with their existing obligations? What costs would there be for investors? 100. The Commission seeks comment on the types of labor and other resources that would be required for firms to comply with the proposed conflicts rules and proposed recordkeeping amendments. What personnel would need to be involved in complying with the proposed conflicts rules and proposed recordkeeping amendments? What types of expertise would be required? How might the size and complexity of a firm impact the resources needed to comply with the proposed conflicts rules and proposed recordkeeping amendments? 101. The Commission seeks comment on how the proposed conflicts rules and proposed recordkeeping amendments might impact a firm’s or a technology E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules provider’s software development process. What changes might be necessary in order to help ensure that firms using covered technologies in investor interactions are in compliance with the proposed conflicts rules and proposed recordkeeping amendments? How might the proposed conflicts rules and proposed recordkeeping amendments impact the speed or efficiency of software development? 102. The Commission seeks comment on the potential impact of the proposed conflicts rules and proposed recordkeeping amendments on smaller firms, or firms with simpler or more transparent covered technologies. What additional costs might these firms face in order to comply with the proposed conflicts rules and proposed recordkeeping amendments? How might these costs impact smaller firms and their investors differently than larger firms and their investors? 103. The Commission seeks comment on the potential benefits of the proposed conflicts rules and proposed recordkeeping amendments. How might the proposed conflicts rules and proposed recordkeeping amendments improve transparency and fairness in the use of covered technologies? What impact might this have on investor confidence and trust in the market? 104. The Commission seeks comment on the potential alternatives to the proposed conflicts rules and proposed recordkeeping amendments. Are there other approaches that might be more effective at achieving the goals of the proposed conflicts rules and proposed recordkeeping amendments? What trade-offs might be involved in pursuing these alternatives? 105. Are the economic effects of the above alternatives accurately characterized? If not, why not? Should any of the costs or benefits be modified? What, if any, other costs or benefits should be taken into account? 106. Are there other reasonable alternatives to the proposed conflicts rules and proposed recordkeeping amendments that should be considered? What are the costs, benefits, and effects on competition, efficiency, and capital formation of any other alternatives? IV. Paperwork Reduction Act lotter on DSK11XQN23PROD with PROPOSALS2 A. Introduction Certain provisions of our proposal would result in new ‘‘collection of information’’ requirements within the meaning of the Paperwork Reduction Act of 1995 (‘‘PRA’’).339 Proposed rule 15l–2 under the Exchange Act and 339 44 U.S.C. 3501 et seq. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 proposed rule 211(h)(2)–4 under the Advisers Act would result in new collection of information burdens and related amendments to rule 17a–3 and 17a–4 under the Exchange Act and rule 204–2 under the Advisers Act and would have an impact on current collection of information burdens. The titles of the new collection of information requirements we are proposing are ‘‘Rule 211(h)(1)–4 under the Advisers Act’’ and ‘‘Rule 15l–2 under the Exchange Act.’’ The Office of Management and Budget (‘‘OMB’’) has not yet assigned control numbers for these new collections of information. The titles for the existing collections of information that we are proposing to amend are: (i) ‘‘Rule 204–2 under the Investment Advisers Act of 1940’’ (OMB control number 3235–0278); and (ii) ‘‘Rule 17a–3 and Rule 17a–4 under the Exchange Act’’ (OMB control numbers 3235–0033 and 3235–0279). The Commission is submitting these collections of information to the OMB for review and approval in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently valid OMB control number. We discuss below the new collection of information burdens associated with the proposed new rules, and amendments to existing rules. Responses provided to the Commission in the context of its examination and oversight program concerning the proposed rules and corresponding amendments would be kept confidential subject to the provisions of applicable law. A description of the proposed new rules and proposed amendments to existing rules, including the need for the information and its use, as well as a description of the types of respondents, can be found in section II above, and a discussion of the expected economic effects of the proposed new rules and proposed amendments to existing rules can be found in section III above. B. Proposed Conflicts Rules and Proposed Recordkeeping Amendments The proposed conflicts rules are designed to address the conflicts of interest associated with firms’ use of certain technology when engaging in certain investor interactions. As discussed in greater detail above, the proposed conflicts rules would generally require the elimination or neutralization of the effects of certain conflicts of interest. Specifically, paragraph (b) of the proposed conflicts rules would require a firm to (i) evaluate any use or reasonably foreseeable PO 00000 Frm 00057 Fmt 4701 Sfmt 4702 54015 potential use by the firm of a covered technology in any investor interaction to identify any conflict of interest associated with that use or potential use (including by testing each such covered technology prior to its implementation or material modification, and periodically thereafter, to determine whether the use of such covered technology is associated with a conflict of interest); (ii) determine whether any such conflict of interest places or results in placing the firm’s or an associated persons interest ahead of investors’ interests; and (iii) eliminate, or neutralize the effect of, any such conflict of interest.340 As also discussed above, paragraph (c) of the proposed rules would require a firm that has any investor interaction using covered technology to adopt, implement, and in the case of broker-dealers, maintain written policies and procedures that are, in the case of investment advisers, reasonably designed to prevent violations of, or in the case of brokerdealers, reasonably designed to achieve compliance with, paragraph (b) of the rules. We believe that paragraph (c) constitutes a collection of information. We do not believe that the proposed requirements under paragraph (b) constitute an independent information collection. But, to the extent they do, we believe that the process firms would engage in to comply with the policies and procedures requirements under paragraph (c) of the proposed conflicts rules, and the information collection burden related thereto, are inextricable from any information collection burden under paragraph (b) of the proposed conflicts rules. Therefore, the information collection burden resulting from the policies and procedures required under the proposed conflicts rules would constitute the full burden of the rules. Finally, the proposed recordkeeping amendments would require investment advisers that are registered or required to be registered under the Advisers Act and broker-dealers that use covered technologies in investor interactions to make and maintain written records documenting compliance with the requirements of the proposed conflicts rules. Under the proposed recordkeeping amendments, the time periods for preserving records would vary between those for investment advisers that are registered or required to be registered under the Advisers Act and broker-dealers, in accordance with the existing recordkeeping rules that 340 See proposed rule 211(h)(2)–4(b); see also supra sections II.A.1 and II.A.2.c. E:\FR\FM\09AUP2.SGM 09AUP2 54016 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules would be amended.341 Time periods for maintaining records where they are easily accessible would be the same between investment advisers and broker-dealers.342 Each of the proposed requirements to obtain or maintain information constitutes a ‘‘collection of information’’ requirement under the PRA and is mandatory. These proposed collections are designed to require firms to have an established framework for eliminating or neutralizing conflicts of interest that could harm clients and which we believe would assist these firms in complying with the requirements under paragraph (b)(3) of the proposed rules. Accordingly, we believe the proposal would have investor protection benefits. Additionally, the Commission’s staff could use the information obtained through these collections in its enforcement, regulatory, and examination programs. The respondents to these collections of information requirements would be investment advisers that are registered or required to be registered under the Advisers Act and broker-dealers that are registered under the Exchange Act that used covered technologies in investor interactions. As of February 28, 2023, there were 15,402 investment advisers registered with the Commission 343 and 3,504 344 broker-dealers registered with the Commission. We believe that substantially all of the 15,402 registered investment advisers would be subject to the proposed rules and, based on an analysis of filings by these firms performed by the staff, we believe that approximately 2,575 345 broker-dealers would be subject to the proposed rules. The application of the provisions of the proposed conflicts rules and proposed recordkeeping amendments— and thus the extent to which there are collections of information and their related burdens—would be contingent on a number of factors, such as, among others, the types of covered technologies a firm uses, a firm’s business model, the number of clients or customers of the firm, the extent, nature and frequency of investor interactions, and the nature and extent of its conflicts. Because of the wide diversity of services and relationships offered by firms, we expect that the obligations imposed by the proposed rules would, accordingly, vary substantially. However, we have made certain estimates of this data solely for the purpose of this PRA analysis. TABLE 3—PROPOSED CONFLICTS RULES AND PROPOSED RECORDKEEPING AMENDMENTS Internal initial burden hours 1 Internal annual burden hours 2 Adopting and implementing policies and procedures. Preparation of written descriptions 6. 21 hours ... 30 hours ... 60 hours ... 42.5 hours Annual review of policies and procedures and written descriptions. Recordkeeping requirements 7. ................... 5 hours ..... N/A ............ 18.5 hours Total new annual burden. ................... Number of investment advisers covered. ................... Number of broker-dealers covered. ................... Total new annual aggregate burden for investment advisers covered. Total new annual aggregate burden for broker-dealers covered. ................... 96 hours (equal to the sum of the above four boxes). × 15,402 covered investment advisers 7. × 2,573 covered brokerdealers. 1,478,592 hours. Wage rate 3 Internal time cost 4 Annual external cost burden 5 lotter on DSK11XQN23PROD with PROPOSALS2 PROPOSED ESTIMATES ................... 247,008 hours. $487 (blended rate for senior corporate and information technology managers, assistant general counsel, and compliance attorney). $446 (blended rate for senior corporate and information technology managers and staff, assistant general counsel, and compliance attorney). $446 (blended rate for senior corporate and information technology managers and staff, assistant general counsel, and compliance attorney). $412 (blended rate for compliance attorney, senior programmer, and senior corporate manager). ............................................................................ $14,610 (equal to the internal annual burden × the wage rate). $0. $18,955 (equal to the internal annual burden × the wage rate). $0. $2,230 (equal to the internal annual burden hours × the wage rate). $0. $7,622 (equal to the internal annual burden hours × the wage rate). $43,417 (equal to the sum of the above four boxes). $0. $0 (equal to the sum of the above four boxes). ............................................................................ × 15,402 covered investment advisers. $0. ............................................................................ × 2,573 covered broker-dealers ..... $0. ............................................................................ $668,708,634 .................................. $0. ............................................................................ $ 111,711,941 ................................ $0. Notes: 341 Pursuant to current rule 204–2(e)(1), the records required to be maintained and preserved under proposed amendments to rule 204–2 under the Advisers Act would be required to be maintained and preserved in an easily accessible place for a period of not less than five years from the end of the fiscal year during which the last entry was made on such record, the first two years VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 in an appropriate office of the investment adviser. For broker-dealers, rule 17a–4(a) requires that records be ‘‘preserve[d] for a period of not less than 6 years, the first two years in an easily accessible place.’’ See also supra section II.B. 342 See id. 343 Based on IARD data as of Mar. 27, 2023. PO 00000 Frm 00058 Fmt 4701 Sfmt 4702 344 Based on FOCUS Filing data, as of Mar. 2023. with the Form CRS Adopting Release, we estimate that 73.5% of registered broker-dealers report retail activity and thus, would likely be subject to the proposed rules. However, we recognize this may capture some broker-dealers that do not have retail activity. 345 Consistent E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules 54017 1 In the case of investment advisers, most advisers using covered technology already have certain policies and procedures in place relevant to these technologies so as to fulfill the adviser’s fiduciary duty, comply with the Federal securities laws, and protect clients from potential harm. Similarly, broker-dealers are already subject to extensive obligations, including certain policies and procedures requirements, under Federal securities laws and regulations, and rules of self-regulatory organizations (in particular, FINRA) that would apply to the extent PDA-like technologies are used in investor interactions that are subject to such existing obligations. In reaching our estimates, we considered that advisers and broker-dealers relying more heavily on complex covered technologies may exceed this average, while advisers and broker-dealers relying less heavily on these technologies may fall below this average. 2 Totals for this category include internal initial hour burden estimates annualized over a three-year period. 3 The Commission’s estimates of the relevant wage rates are based on salary information for the securities industry compiled by Securities Industry and Financial Markets Association’s Office Salaries in the Securities Industry 2013, as modified by Commission staff for 2023 (‘‘SIFMA Wage Report’’). The estimated figures are modified by firm size, employee benefits, overhead, and adjusted to account for the effects of inflation. 4 All costs calculated are rounded to the nearest dollar. 5 Firms may incur third-party costs in connection with the proposed conflicts rules but, due to data limitations, for the purpose of this Paperwork Reduction Act analysis, we estimate the full cost of compliance to be internal. See supra section III.C.1. (discussing data limitations). 6 Includes all written descriptions to be required under proposed rules 275.211(h)(2)–4(c)(1) through (3) and 240.15l–2 (c)(1) through (3). 7 In our most recent Paperwork Reduction Act submission for rule 204–2, we estimated for rule 204–2 a total annual aggregate hour burden of 2,764,563 hours, and a total annual aggregate external cost burden of $175,980,426. The table above summarizes the initial and ongoing annual burden estimates associated with the proposed amendments to rule 204–2. We have made certain estimates of the burdens associated with the proposed amendments solely for the purpose of this PRA analysis. We estimate that the proposed amendments would result in an aggregate burden of 284,937 hours (18.5 hours × 15,402 advisers) and with an estimated aggregate internal monetized cost of $117,394,044 (284,937 hours × $412 blended rate of professional staff described above = $117,394,044). Based on our most recent Paperwork Reduction Act submission, we believe that the total burden under rule 204–2, including the proposed amendments to rule 204–2, amount to 3,049,500 hours with a total internal monetized cost of $293,374,470. lotter on DSK11XQN23PROD with PROPOSALS2 C. Request for Comment We request comment on whether these estimates are reasonable. Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments in order to: (i) evaluate whether the proposed collection of information is necessary for the proper performance of the functions of the Commission, including whether the information will have practical utility; (ii) evaluate the accuracy of the Commission’s estimate of the burden of the proposed collection of information; (iii) determine whether there are ways to enhance the quality, utility, and clarity of the information to be collected; and (iv) determine whether there are ways to minimize the burden of the collection of information on those who are to respond, including through the use of automated collection techniques or other forms of information technology. Persons wishing to submit comments on the collection of information requirements of the proposed amendments should direct them to the OMB Desk Officer for the Securities and Exchange Commission, MBX.OMB.OIRA.SEC_desk_officer@ omb.eop.gov, and should send a copy to Vanessa A. Countryman, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–1090, with reference to File No. S7–12–23. OMB is required to make a decision concerning the collections of information between 30 and 60 days after publication of this release; therefore, a comment to OMB is best assured of having its full effect if OMB receives it within 30 days after publication of this release. Requests for materials submitted to OMB by the Commission with regard to these collections of information should be in writing, refer to File No. S7–12–23, and be submitted to the Securities and Exchange Commission, Office of FOIA Services, 100 F Street NE, Washington, DC 20549–2736. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 V. Initial Regulatory Flexibility Analysis The Commission has prepared the following Initial Regulatory Flexibility Analysis (‘‘IRFA’’) in accordance with section 3(a) of the Regulatory Flexibility Act.346 It relates to: (i) proposed rule 151–2 under the Exchange Act and proposed rule 211(h)(2)–4 under the Advisers Act; and (ii) proposed amendments to rules 17a–3 and 17a–4 under the Exchange Act and rule 204– 2 under the Advisers Act. A. Reason for and Objectives of the Proposed Action The reasons for, and objectives of, the proposed rules and amendments are discussed in more detail in sections I and II, above. The burdens of these requirements on small advisers and broker-dealers are discussed below as well as above in sections III and IV, which discuss the burdens on all advisers and broker-dealers. Sections II through IV discuss the professional skills that we believe compliance with the proposed rules and amendments would require. 1. Proposed Rules 151–2 and 211(h)(2)– 4 We are proposing rules 15l–2 under the Exchange Act and 211(h)(2)–4 under the Advisers Act (collectively, the ‘‘conflicts rules’’) which, generally, would require investment advisers and broker-dealers registered with the Commission to take certain steps to eliminate, or neutralize the effect of, certain conflicts of interest from these firms’ use of covered technology when engaging in certain investor interactions. As firms adopt and utilize covered technologies at an increasingly rapid pace, the risk of conflicts of interest associated with the use of those technologies becomes increasingly pronounced and potentially harmful on a broader scale than previously possible. 346 5 PO 00000 U.S.C. 603(a). Frm 00059 Fmt 4701 Sfmt 4702 In addition, the conflicts associated with a firm’s use of these technologies may expose investors to unique and opaque conflicts of interest for which disclosure may not possible or sufficient and which may not otherwise be sufficiently addressed by the existing legal framework. The proposed conflicts rules, therefore, would require a firm to identify and evaluate whether any use or potential use by the firm of a covered technology in any investor interaction involves a conflict of interest, determine whether any such conflict of interest results in an investor interaction that places the firm’s or an associated person’s interest ahead of investors’ interests, and eliminate, or neutralize the effect of, any such conflict of interest. The proposed conflicts rules would also require a firm that has any investor interaction using covered technology to adopt, implement, and, in the case of broker-dealers, maintain, written policies and procedures reasonably designed to achieve compliance with the elimination and neutralization of effect of conflicts of interest requirement. These proposed policies and procedures requirements, as well as the written descriptions and annual review to be required by those policies and procedures, are designed to require firms to have an established framework for eliminating, or neutralizing the effect of, conflicts of interest that could harm clients and which we believe would assist these firms in complying with the requirements under paragraph (b) of the proposed rules. The description would also assist the firm’s internal staff, as well as examination staff, in assessing a firm’s compliance. In turn, this design would help ensure that firms are appropriately eliminating, or neutralizing the effects of, any conflict of interest in accordance with the proposed rules. The proposed rules would require the policies and procedures to address certain matters that, collectively, are E:\FR\FM\09AUP2.SGM 09AUP2 54018 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 designed to help ensure that a firm understands how its covered technologies work and the actual or potential conflicts they could involve. The policies and procedures would require a firm that has any investor interaction using covered technology to adopt, implement, and maintain written policies and procedures reasonably designed to achieve compliance with the proposed conflicts rules, including policies and procedures designed to require: (i) a written description of any material features of, including any conflicts of interest associated with the use of, any covered technology used in any investor interaction prior to such covered technology’s implementation or material modification, which must be updated periodically thereafter; (ii) a written description of the process for determining whether any conflict of interest identified pursuant to the proposed conflicts rules places or results in placing the interest of the firm or person associated with the firm ahead of the interests of the investor; (iii) 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 conflicts rules to result in an investor interaction that places the interest of the firm or person associated with the firm ahead of the interests of the investor; and (iv) a review and written documentation of that review, no less frequently than annually, of the adequacy of the policies and procedures established pursuant to the proposed conflicts rules and the effectiveness of their implementation as well as a review of the written descriptions established pursuant to the proposed conflicts rules. The proposed conflict rules are designed to promote investor protection while allowing continued technological innovation in the industry. 2. Proposed Amendments to Rules 17a– 3 and 17a–4 and Rule 204–2 Proposed amendments to rules 17a–3 and 17a–4, the books and records rules under the Exchange Act, and proposed amendments to rule 204–2, the books and records rule under the Advisers Act, would require firms to make and keep books and records related to the requirements of the proposed conflicts rules and are designed to help facilitate the Commission’s examination and enforcement capabilities by creating records staff can use to assess compliance with the requirements of the proposed conflicts rules, and to help facilitate assessment by firm compliance staff of such compliance. The rules would require firms to maintain six types of records, as follows, and as more VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 fully described in section II above: (1) written documentation of the evaluation conducted pursuant to paragraph (b)(1) of the proposed conflicts rules, including a list or other record of all covered technologies used by the firm in investor interactions, as well as documentation describing any testing of the covered technology in accordance with paragraph (b)(1) of the proposed conflicts rules; (2) written documentation of each determination made pursuant to paragraph (b)(2) of the proposed conflicts rules, including the rationale for such determination; (3) written documentation of each elimination or neutralization made pursuant to paragraph (b)(3) of the proposed conflicts rules; (4) written policies and procedures, including written descriptions, prepared in accordance with paragraph (c) of the proposed conflicts rules; (5) a record of the disclosures provided to investors regarding the firm’s use of covered technologies; and (6) records of each instance in which a covered technology was altered, overridden, or disabled, the reason for such action, and the date thereof, as well as records of all instances where an investor requested that a covered technology be altered or restricted in any manner. B. Legal Basis The Commission is proposing the new rules and rule amendments described above under the authority set forth in sections 204 and 211 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–4 and 80(b)–11) and sections 15 and 17 of the Securities Exchange Act of 1934 (15 U.S.C. 78j). C. Small Entities Subject to the Rules and Rule Amendments In developing these proposals, we have considered their potential impact on small entities that would be subject to the proposed rules and rule amendments. The proposed rules and amendments would affect investment advisers registered, or required to be registered, with the Commission and broker-dealers registered with the Commission, including some small entities. 1. Small Advisers Subject to Proposed Rule 211(h)(2)–4 and Proposed Amendments to Recordkeeping Rule Under Commission rules under the Advisers Act, for the purposes of the RFA, an investment adviser generally is a small entity if it: (i) has assets under management having a total value of less than $25 million; (ii) did not have total assets of $5 million or more on the last day of the most recent fiscal year; and PO 00000 Frm 00060 Fmt 4701 Sfmt 4702 (iii) does not control, is not controlled by, and is not under common control with another investment adviser that has assets under management of $25 million or more, or any person (other than a natural person) that had total assets of $5 million or more on the last day of its most recent fiscal year. Our proposed rules and amendments would not affect most investment advisers that are small entities (‘‘small advisers’’) because they are generally registered with one or more state securities authorities and not with the Commission. Under section 203A of the Advisers Act, most small advisers are prohibited from registering with the Commission and are regulated by state regulators. We estimate that approximately 489 SEC-registered advisers are small entities under the RFA.347 As discussed above in section IV (the Paperwork Reduction Act Analysis), the Commission estimates that based on IARD data through March 31, 2023, approximately 15,402 investment advisers would be subject to proposed rule 211(h)(2)–4 and the related amendments to the recordkeeping rule. We estimate that all of the approximately 489 SEC-registered advisers that are small entities under the RFA would be subject to the proposed conflicts rules and amendments to the recordkeeping rule. D. Small Broker-Dealers Subject to Proposed Conflicts Rule and Amendments to Recordkeeping Rules For purposes of the RFA, under the Exchange Act a broker or dealer is a small entity if it: (i) had total capital of less than $500,000 on the date in its prior fiscal year as of which its audited financial statements were prepared or, if not required to file audited financial statements, on the last business day of its prior fiscal year; and (ii) is not affiliated with any person that is not a small entity.348 Based on Commission filings, we estimate that approximately 764 broker-dealers may be considered small entities.349 E. Projected Reporting, Recordkeeping, and Other Compliance Requirements The proposed conflicts rules and amendments to rule 204–2 and to rules 17a–3 and 17a–4 would impose certain compliance and recordkeeping requirements on those investment advisers and broker-dealers subject to the terms of the rules, including those 347 Based on IARD data as of Dec. 31, 2022. CFR 240.0–10. 349 Estimate based on FOCUS Report data collected by the Commission as of Sept. 30, 2022. 348 17 E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules that are small entities. All advisers and broker-dealers that have any investor interaction using covered technology would be subject to the proposed conflict rules’ requirement to adopt, implement, and (in the case of brokerdealers) maintain written policies and procedures reasonably designed to achieve compliance with the proposed conflicts rules. These firms would also be subject to the recordkeeping requirements in the proposed amendments to rule 204–2 and rules 17a–3 and 17a–4. The proposed requirements and rule amendments, including compliance, reporting, and recordkeeping requirements, are summarized in this IRFA (section V.A., above). All of these proposed requirements are also discussed in detail, above, in sections I and II, and these requirements and the burdens on respondents, including those that are small entities, are discussed above in sections III and IV (the Economic Analysis and Paperwork Reduction Act Analysis, respectively) and below. The professional skills required to meet these specific burdens are also discussed in section IV. lotter on DSK11XQN23PROD with PROPOSALS2 1. Proposed Conflicts Rules As discussed above, approximately 489 small advisers were registered with us as of December 31, 2022, and we estimate that all of these advisers would be subject to proposed rule 211(h)(2)–4. As discussed above in our Paperwork Reduction Act Analysis in section IV above, proposed rule 211(h)(2)–4 would create an annual burden of approximately 77.5 hours per adviser, or 37,897.5 hours in aggregate for small advisers.350 We therefore expect that the annual monetized aggregate cost to small advisers associated with proposed rule 211(h)(2)–4 would be $17,432,850.351 As discussed above, approximately 764 broker-dealers may be considered small entities as of September 30, 2022, and we estimate that 562 352 of those small registered broker-dealers would be subject to the proposed amendments (73.5% of all registered small brokerdealers). As discussed above in our 350 77.5 hours × 489 small advisers subject to the proposed rule and rule amendments. 351 $460 (blended rate for professionals assisting with adopting and implementing policies and procedures, (ii) preparation of written descriptions, and (iii) annual review of policies and procedures and written descriptions) × 37,897.55 hours. 352 2,573 (estimated number of broker-dealers subject to proposed rule and rule amendments)/ 3,501 (number of registered broker-dealers) = 0.735 (estimated ratio of broker-dealers subject to rule and rule amendments). 0.735 × 764 (number of small broker-dealers) = 562 small broker-dealers subject to proposed rule and rule amendments. VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 Paperwork Reduction Act Analysis in section IV above, proposed rule 15–2 would create an annual burden of approximately 77.5 hours per brokerdealers, 43,555 hours in aggregate for small broker-dealers.353 We therefore expect that the annual monetized aggregate cost to small broker-dealers associated with proposed rule 15l-2 would be $20,035,300.354 2. Proposed Amendments to Rule 204– 2 The proposed amendments to rule 204–2 would impose certain recordkeeping requirements on investment advisers using covered technology in interactions with investors. The proposed amendments, including recordkeeping requirements, are summarized above in this IRFA (section V.A). All of these proposed requirements are also discussed in detail, above, in section II, and these requirements and the burdens on respondents, including those that are small entities, are discussed above in sections III and IV (the Economic Analysis and Paperwork Reduction Act Analysis) and below. The professional skills required to meet these specific burdens are also discussed in section IV. Our Economic Analysis (section III above) discusses these costs and burdens for respondents, which include small advisers. As discussed above in our Paperwork Reduction Act Analysis in section IV above, the proposed amendments to rule 204–2 would create an annual burden of approximately 18.5 hours per adviser. Based on our estimate of 489 advisers subject to the proposed amendments to the rule, we estimate the aggregate burden on small advisers to amount to 9,046.5 hours.355 We therefore expect that the annual monetized aggregate cost to small advisers associated with the proposed amendments to rule 204–2 would be $3,727,158.356 3. Proposed Amendments to Rules 17a– 3 and 17a–4 The proposed amendments to rules 17a–3 and 17a–4 would impose certain recordkeeping requirements on brokerdealers using covered technology in interactions with investors. The proposed amendments, including 353 77.5 hours × 562 small broker-dealers subject to the proposed rule and rule amendments. 354 $460 (blended rate for professionals assisting with adopting and implementing policies and procedures, (ii) preparation of written descriptions, and (iii) annual review of policies and procedures and written descriptions) × 43,555 hours. 355 18.5 hours × 489 advisers. 356 $412 (blended rate for compliance attorney, senior programmer, and senior corporate manager) × 9,046.5 hours. PO 00000 Frm 00061 Fmt 4701 Sfmt 4702 54019 recordkeeping requirements, are summarized above in this IRFA (section V.A). All of these proposed requirements are also discussed in detail, above, in section II, and these requirements and the burdens on respondents, including those that are small broker-dealers, are discussed above in sections III and IV (the Economic Analysis and Paperwork Reduction Act Analysis) and below. The professional skills required to meet these specific burdens are also discussed in section IV. Our Economic Analysis (section III above) discusses these costs and burdens for respondents, which include small broker-dealers. As discussed above in our Paperwork Reduction Act Analysis in section IV above, the proposed amendments to rules 17a–3 and 17a–4 would create an annual burden of approximately 18.5 hours per broker-dealer. Based on our estimate of 562 small broker-dealers subject to the proposed amendments to the rule, we estimate the aggregate burden on small broker-dealers to amount to 10,397 hours.357 We therefore expect that the annual monetized aggregate cost to small broker-dealers associated with the proposed amendments to rules 17a–3 and 17a–4 would be $4,283,564.358 F. Duplicative, Overlapping, or Conflicting Federal Rules 1. Proposed Rule 211(h)(2)–4 and Proposed Amendments to Rule 204–2 In proposing rule 211(h)(2)–4, we recognize that investment advisers today are subject to a number of laws, rules, and regulations which indirectly address the oversight of the way an adviser relies on and uses technology in its interactions with advisory clients. As discussed in section I and section III.C.3, their fiduciary duty requires them to take steps to protect client interests, which would include steps to provide investment advice that it reasonably believes is in the best interest of the client regardless of whether the adviser is using a covered technology in an investor interaction. This duty requires investment advisers to eliminate a conflict of interest or, at a minimum, make full and fair disclosure of the conflict of interest such that a client can provide informed consent to the conflict.359 Investment advisers are subject to the antifraud provisions found in section 206 of the hours × 562 small broker-dealers. (blended rate for compliance attorney, senior programmer, and senior corporate manager) × 10,397 hours. 359 See Fiduciary Interpretation, supra note 8, at section II. 357 18.5 358 $412 E:\FR\FM\09AUP2.SGM 09AUP2 54020 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 Advisers Act,360 which prohibits fraud or deceit upon any client or prospective client; rule 206(4)–8 under the Advisers Act, which makes it unlawful for any investment adviser to a pooled investment vehicle to engage in fraud or deceit upon any investor or prospective investor in the pooled investment vehicle; 361 and Exchange Act rule 10b– 5, which makes it unlawful for any person to engage in fraud or deceit upon any person.362 Advisers are also subject to the Advisers Act Compliance Rule, requiring advisers to adopt, implement, and annually review written policies and procedures reasonably designed to prevent violations of the Act and the rules thereunder,363 and rule 206(4)–1 under the Advisers Act, prohibiting advisers from disseminating any advertisement that violates any requirements of that rule, including making untrue statements of material fact or misleading omissions and discussing any potential benefits connected with or resulting from the investment adviser’s services or methods of operation without providing fair and balanced treatment of any material risks or material limitations associated with the potential benefits.364 Individually and collectively, these impose obligations on an adviser’s use of covered technologies in investor interactions depending on how the adviser uses the technology. However, investment advisers do not have specific obligations under the Advisers Act or any of its rules to eliminate, or neutralize the effect of, conflicts of interest promptly after the adviser identifies, or reasonably should have identified, such conflict of interest.365 Further, the Advisers Act compliance rule is principles based and, as such, does not require specific elements that would be required under the policies and procedures requirements of the proposed conflict rule.366 Similarly, existing recordkeeping obligations do not specifically require the records that firms would be required to keep under the proposed amendments to that rule.367 The proposed rules would provide a comprehensive oversight framework, consisting of targeted obligations, policies and procedures, and recordkeeping requirements, which we believe would be complementary to 360 15 U.S.C. 80b–6. CFR 275.206(4)–8. 362 17 CFR 240.10b–5. 363 See rule 206(4)–7. 364 See rule 206(4)–1(a)(1), (4). 365 See proposed rule 211(h)(2)–4(b). 366 See proposed rule 211(h)(2)–4(c). 367 See proposed rule 204–2. 361 17 VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 existing obligations and practices rather than duplicative or conflicting. To the extent there is overlap among the existing and proposed requirements, it is incomplete overlap and would ease burdens on smaller firms in complying with the proposed rules. 2. Proposed Rule 151–2 and Proposed Amendments to Rules 17a–3 and 17a– 4 As noted above, broker-dealers are currently subject to extensive obligations under Federal securities laws and regulations, and rules of selfregulatory organizations (in particular, FINRA), that are designed to promote conduct that, among other things, protects investors from conflicts of interest.368 To the extent PDA-like technologies are used in investor interactions that are subject to existing obligations (including, but not limited to, obligations related to recommendations, general and specific requirements aimed at addressing certain conflicts of interest, including requirements to eliminate, mitigate or disclose certain conflicts of interest, disclosure of firms’ services, fees and costs, disclosure of certain business practices, communications with the public, supervision, and obligations related to policies and procedures), those obligations would apply. In addition to these obligations, Federal securities laws and regulations broadly prohibit fraud by broker-dealers as well as fraud by any person in the offer, purchase, or sale of securities, or in connection with the purchase or sale of securities. However, broker-dealers do not have specific obligations under the Exchange Act or any of its rules to eliminate, or neutralize the effect of, conflicts of interest in the same way as required under proposed rule 151–2. Similarly, while existing recordkeeping obligations apply more generally to 368 See Reg BI Adopting Release, supra note 8, at section II.A.1. (The ‘‘without placing the financial or other interest . . . ahead of the interest of the retail customer’’ phrasing recognizes that while a broker-dealer will inevitably have some financial interest in a recommendation—the nature and magnitude of which will vary—the broker-dealer’s interests cannot be placed ahead of the retail customer’s interest’’). Additionally, broker-dealers often provide a range of services that do not involve a recommendation to a retail customer—which is required in order for Reg BI to apply—and those services are subject to general and specific requirements to address associated conflicts of interest under the Exchange Act, Securities Act of 1933, and relevant SRO rules as applicable. See, e.g., Reg BI Proposing Release, supra note 8; see also FINRA Conflict Report, supra note 60, at Appendix I (Conflicts Regulation in the United States and Selected International Jurisdictions) (describing broad obligations under SEC and FINRA rules as well as specific conflicts-related disclosure requirements under FINRA rules). PO 00000 Frm 00062 Fmt 4701 Sfmt 4702 ‘‘business’’ records, they do not specifically require the records that firms would be required to keep under the proposed amendments to the proposed conflict rule for brokerdealers. The proposed rules would provide a comprehensive oversight framework, consisting of targeted obligations, policies and procedures, and recordkeeping requirements, which we believe would be complementary to existing obligations and practices rather than duplicative or conflicting. To the extent there is overlap among the existing and proposed requirements, it is incomplete overlap and would ease burdens on smaller firms in complying with the proposed rules. G. Significant Alternatives The RFA directs the Commission to consider significant alternatives that would accomplish our stated objectives, while minimizing any significant adverse impact on small entities. In connection with the proposed rules and rule amendments, the Commission considered the following alternatives: (i) the establishment of differing compliance or reporting requirements or timetables that take into account the resources available to small entities; (ii) the clarification, consolidation, or simplification of compliance and reporting requirements under the proposed rules and rule amendments for such small entities; (iii) the use of performance rather than design standards; and (iv) an exemption from coverage of the proposed rules and rule amendments, or any part thereof, for such small entities. Regarding the first and fourth alternatives, we do not believe that differing compliance or reporting requirements or an exemption from coverage of the proposed rules and rule amendments, or any part thereof, for small entities, would be appropriate or consistent with investor protection. Because the protections of the Advisers Act and Exchange Act are intended to apply equally to clients and customers of both large and small advisory and brokerage firms, it would be inconsistent with the purposes of the Advisers Act and Exchange Act to specify different requirements for small entities under the proposed rules and rule amendments. We believe there has been, and will continue to be, rapid adoption and use of covered technologies in the industry,369 and that the effects of conflicts of interest associated with these covered technologies are contrary to the public interest and the protection of 369 See E:\FR\FM\09AUP2.SGM supra section I.B. 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules investors.370 Consequently, we believe that investors would receive important protections under the proposed conflicts rules and proposed recordkeeping amendments and that establishing different conditions for large and small firms, when investors use both large and small firms, would negate these benefits. Regarding the second alternative, the proposed conflicts rules and amendments to rule 204–2 and rules 17a–3 and 17a–4 are intended to prohibit conduct that the Commission considers to be contrary to the public interest and protection of investors under section 211 of the Advisers Act and Section 15 of the Exchange Act. We have endeavored to consolidate and simplify the compliance requirements under the proposed conflicts rules and the proposed amendments to rule 204– 2 and 17a–3 and 17a–4 for all firms, and we do not believe that the goal of the proposed conflicts rules and proposed recordkeeping amendments of enhancing investor protection would be achieved as well by further consolidating or simplifying the requirements. In addition, the proposed conflicts rules provide minimum standards for all covered technologies, but the elimination and neutralization requirement would only affect firms whose use of covered technology is actually determined to place the interests of the firm ahead of investors, meaning certain aspects of the proposed conflicts rules would only have an impact on small entities to the extent that the entities’ use of covered technologies places their interests ahead of investors. Regarding the third alternative, we determined to use a combination of performance and design standards. Although the proposed conflicts rules would require firms to undertake certain functions relating to the elimination or neutralization of the effect of certain conflicts of interest and requires firms to adopt, implement, and, in the case of broker-dealers, maintain, certain policies and procedures reasonably designed to achieve compliance with the requirement to eliminate, or neutralize the effect of, certain conflicts of interest,371 the proposed conflicts rules would allow firms a broad range of flexibility in complying with these requirements. For example, as described in detail in section II.A.2.e., firms have flexibility in determining whether to eliminate a conflict of interest or neutralize the effect of the conflict. Similarly, in light of the broad range of id. 371 See supra section II. 19:26 Aug 08, 2023 H. Solicitation of Comments We encourage written comments on the matters discussed in this IRFA. We solicit comment on the number of small entities subject to the proposed conflicts rules and the proposed amendments to rule 204–2 and rules 17a–3 and 17a–4, as well as the potential impacts discussed in this analysis; and whether the proposal could have an effect on small entities that has not been considered. We request that commenters describe the nature of any impact on small entities and provide empirical data to support the extent of such impact. VI. Consideration of Impact on the Economy For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996, or ‘‘SBREFA,’’ 372 we must advise OMB whether a proposed regulation constitutes a ‘‘major’’ rule. Under SBREFA, a rule is considered ‘‘major’’ where, if adopted, it results in or is likely to result in (i) an annual effect on the economy of $100 million or more; (ii) a major increase in costs or prices for consumers or individual industries; or (iii) significant adverse effects on competition, investment or innovation. We request comment on the potential impact of the proposed conflicts rules and proposed recordkeeping amendments on the economy on an annual basis. Commenters are requested to provide empirical data and other factual support for their views to the extent possible. 372 Public Law 104–121, Title II, 110 Stat. 857 (1996) (codified in various sections of 5 U.S.C., 15 U.S.C., and as a note to 5 U.S.C. 601). 370 See VerDate Sep<11>2014 covered technology and investor interactions, the proposed conflicts rules provide firms with flexibility in their evaluation of any use or reasonably foreseeable potential use by the firm or its associated person of a covered technology and flexibility in their determination of whether any such conflict of interest places or results in placing the firm’s or its associated person’s interest ahead of investors’ interests. We believe that flexibility is appropriate, but also believe that certain of the design standards in the proposed conflicts rules and proposed recordkeeping amendments are necessary to, among other things, facilitate the Commission’s examination and enforcement capabilities by creating records staff can use to assess compliance with the requirements of the proposed conflicts rules, and to help facilitate assessment by firm compliance staff of such compliance. Jkt 259001 PO 00000 Frm 00063 Fmt 4701 Sfmt 4702 54021 Statutory Authority The Commission is proposing new rule 240.151–2 under the Exchange Act under the authority set forth in section 15 of the Exchange Act (15 U.S.C. 78j). The Commission is proposing amendments to §§ 240.17a–3 and 17a–4 under the Exchange Act under the authority set forth in section 17 of the Exchange Act (15 U.S.C. 78q). The Commission is proposing new rule 211(h)(2)–4 under the Advisers Act under the authority set forth in section 211 of the Investment Advisers Act (15 U.S.C. 80b–11(a) and (h)). The Commission is proposing amendments to rule 204–2 under the Advisers Act under the authority set forth in sections 204 and 211 of the Investment Advisers Act (15 U.S.C. 80b–4 and 80b–11). List of Subjects in 17 CFR Parts 240 and 275 Brokers, Reporting and recordkeeping requirements; Securities. Text of Proposed Rules and Form Amendments For the reasons set out in the preamble, the SEC proposes to amend title 17, chapter II of the Code of Federal Regulations as follows: PART 240—GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934 1. The authority citation for part 240 is amended to read, in part, as follows: ■ Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 7 7z–2, 77z–3, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c–3, 78c–5, 78d, 78e, 78f, 78g, 78i, 78j, 78j–1, 78j–4, 78k, 78k–1, 78l, 78m, 78n, 78n–1, 78o, 78o–4, 78o–10, 78p, 78q, 78q–1, 78s, 78u–5, 78w, 78x, 78dd, 78ll, 78mm, 80a–20, 80a–23, 80a–29, 80a–37, 80b– 3, 80b–4, 80b–11, 7201 et seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C.5221(e)(3); 18 U.S.C. 1350; and Pub. L. 111–203, 939A, 124 Stat.1376 (2010); and Pub. L. 112–106, sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise noted * ■ * * * * 2. Add § 240.15l–2 to read as follows: § 240.15l–2 Prohibition against conflicts associated with investor interactions employing covered technology. (a) Definitions. For purposes of this section: Conflict of interest exists when a broker or dealer uses a covered technology that takes into consideration an interest of the broker or dealer, or a natural person who is an associated person of a broker or dealer. Covered technology means an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar E:\FR\FM\09AUP2.SGM 09AUP2 lotter on DSK11XQN23PROD with PROPOSALS2 54022 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes. Investor means a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes. Investor interaction means 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; except that the term does not apply to interactions solely for purposes of meeting legal or regulatory obligations or providing clerical, ministerial, or general administrative support. (b) Elimination or neutralization of the effect of conflicts of interest. A broker or dealer must: (1) Evaluate any use or reasonably foreseeable potential use of a covered technology by the broker or dealer, or a natural person who is an associated person of a broker or dealer, in any investor interaction to identify any conflict of interest associated with that use or potential use (including by testing each such covered technology prior to its implementation or material modification, and periodically thereafter, to determine whether the use of such covered technology is associated with a conflict of interest); (2) Determine if any conflict of interest identified pursuant to paragraph (b)(1) of this section places or results in placing the interest of the broker or dealer, or a natural person who is an associated person of a broker or dealer ahead of the interests of investors; and (3) Eliminate, or neutralize the effect of, any conflict of interest (other than conflicts of interest that exist solely because the broker or dealer seeks to open a new investor account) determined pursuant to paragraph (b)(2) of this section to result in an investor interaction that places the interest of the broker or dealer, or a natural person who is an associated person of a broker or dealer, ahead of the interests of investors, promptly after the broker or dealer determines, or reasonably should have determined, that the conflict of interest placed the interests of the broker or dealer, or a natural person who is an associated person of a broker or dealer, ahead of the interests of investors. (c) Policies and procedures. A broker or dealer that is subject to paragraph (b) of this section and that has any investor interaction using covered technology must adopt, implement, and maintain written policies and procedures VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 reasonably designed to achieve compliance with paragraph (b) of this section, including: (1) A written description of the process for evaluating any use or reasonably foreseeable potential use of a covered technology in any investor interaction pursuant to paragraph (b)(1) of this section and a written description of any material features of, including any conflicts of interest associated with the use of, any covered technology used in any investor interaction prior to such covered technology’s implementation or material modification, which must be updated periodically; (2) A written description of the process for determining whether any conflict of interest identified pursuant to paragraph (b)(1) of this section results in an investor interaction that places the interest of the broker or dealer, or a natural person who is an associated person of a broker or dealer ahead of the interests of investors; (3) A written description of the process for determining how to eliminate, or neutralize the effect of, any conflicts of interest determined pursuant to paragraph (b)(2) of this section to result in an investor interaction that places the interest of the broker or dealer or a natural person who is an associated person of a broker or dealer ahead of the interests of investors; and (4) A review and written documentation of that review, no less frequently than annually, of the adequacy of the policies and procedures established pursuant to this section and the effectiveness of their implementation as well as a review of the written descriptions established pursuant to this section. ■ 3. Amend § 240.17a–3 by adding paragraph (a)(36) to read as follows: § 240.17a–3 Records to be made by certain exchange members, brokers and dealers. * * * * * (a) * * * * * * * * (36) All records required to be made and maintained pursuant to § 240.15l–2, including: (i) Written documentation of the evaluation conducted pursuant to § 240.15l–2(b)(1), including: (A) A list or other record of all covered technologies used in investor interactions by the broker or dealer, including: (1) The date on which each covered technology is first implemented, and each date on which any covered technology is materially modified; and (2) The broker or dealer’s evaluation of the intended as compared to the PO 00000 Frm 00064 Fmt 4701 Sfmt 4702 actual use and outcome of each covered technology in investor interactions. (B) Documentation describing any testing of the covered technology in accordance with § 240.15l–2(b)(1), including: (1) The date on which testing was completed; (2) The methods used to conduct the testing; (3) Any actual or reasonably foreseeable potential conflicts of interest identified as a result of the testing; (4) A description of any changes or modifications to the covered technology made as a result of the testing and the reason for those changes; and (5) Any restrictions placed on the broker or dealer’s use of the covered technology as a result of the testing. (ii) Written documentation of each determination made pursuant to § 240.15l–2(b)(2), including the rationale for such determination. (iii) Written documentation of each elimination or neutralization made pursuant to § 240.15l–2(b)(3). (iv) The written policies and procedures prepared in accordance with § 240.15l–2(c), including any written description and the date on which the policies and procedures were last reviewed. (v) A record of any disclosures provided to each investor regarding the broker or dealer’s use of covered technologies, including, if applicable, the date such disclosure was provided or updated. (vi) A record of each instance in which a covered technology was altered, overridden, or disabled, the reason for such action, and the date thereof, including a record of all instances where an investor requested that a covered technology be altered or restricted in any manner. (vii) For the purposes of this paragraph, the terms covered technology, investor, investor interaction, and conflict of interest have the same meanings as set forth in § 240.15l–2. ■ 4. Amend § 240.17a–4 by amending paragraph (a) to read as follows: § 240.17a–4 Records to be preserved by certain exchange members, brokers and dealers. * * * * * (a) Every member, broker or dealer subject to § 240.17a–3 must preserve for a period of not less than six years, the first two years in an easily accessible place, all records required to be made pursuant to § 240.17a–3(a)(1) through (3), (5), (21), (22), and (36) and analogous records created pursuant to § 240.17a–3(e). * * * * * E:\FR\FM\09AUP2.SGM 09AUP2 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules PART 275—RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940 5. The authority citation for part 275 continues to read, in part, as follows: ■ Authority: 15 U.S.C. 80b–2(a)(11)(G), 80b– 2(a)(11)(H), 80b–2(a)(17), 80b–3, 80b–4, 80b– 4a, 80b–6(4), 80b–6a, and 80b–11, unless otherwise noted. * * * * * Section 275.204–2 is also issued under 15 U.S.C. 80b–6. * * * * * 6. Amend § 275.204–2 by: a. Adding and reserving paragraphs (a)(20) through (23); and ■ b. Adding paragraph (a)(24). The addition reads as follows: ■ ■ lotter on DSK11XQN23PROD with PROPOSALS2 § 275.204–2 Books and records to be maintained by investment advisers. (a) * * * (20)–(23) [Reserved] (24) All records required to be made and maintained pursuant to § 275.211(h)(2)–4, including: (i) Written documentation of the evaluation conducted pursuant to § 275.211(h)(2)–4(b)(1), including: (A) A list or other record of all covered technologies used in investor interactions by the investment adviser, including: (1) The date on which each covered technology is first implemented, and each date on which any covered technology is materially modified; and (2) The investment adviser’s evaluation of the intended as compared to the actual use and outcome of each covered technology in investor interactions. (B) Documentation describing any testing of the covered technology in accordance with § 275.211(h)(2)–4(b)(1), including: (1) The date on which testing was completed; (2) The methods used to conduct the testing; (3) Any actual or reasonably foreseeable potential conflicts of interest identified as a result of the testing; (4) A description of any changes or modifications to the covered technology made as a result of the testing and the reason for those changes; and (5) Any restrictions placed on the investment adviser’s use of the covered technology as a result of the testing. (ii) Written documentation of each determination made pursuant to § 275.211(h)(2)–4(b)(2), including the rationale for such determination. (iii) Written documentation of each elimination or neutralization made pursuant to § 275.211(h)(2)–4(b)(3). (iv) The written policies and procedures prepared in accordance with VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 § 275.211(h)(2)–4(c), including any written description and the date on which the policies and procedures were last reviewed. (v) A record of any disclosures provided to each investor regarding the investment adviser’s use of covered technologies, including, if applicable, the date such disclosure was provided or updated. (vi) A record of each instance in which a covered technology was altered, overridden, or disabled, the reason for such action, and the date thereof, including a record of all instances where an investor requested that a covered technology be altered or restricted in any manner. (vii) For the purposes of this paragraph, the terms covered technology, investor, investor interaction, and conflict of interest have the same meanings as set forth in § 275.211(h)(2)–4. ■ 7. Add § 275.211(h)(2)–4 to read as follows: § 275.211(h)(2)–4 Prohibition against conflicts associated with investor interactions employing covered technology. (a) Definitions. For purposes of this section: Conflict of interest exists when an investment adviser uses a covered technology that takes into consideration an interest of the investment adviser, or a natural person who is a person associated with the investment adviser. Covered technology means an analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment–related behaviors or outcomes. Investor means any prospective or current client of an investment adviser or any prospective or current investor in a pooled investment vehicle (as defined in § 275.206(4)–8) advised by the investment adviser. Investor interaction means 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; except that the term does not apply to interactions solely for purposes of meeting legal or regulatory obligations or providing clerical, ministerial, or general administrative support. (b) Elimination or neutralization of the effect of conflicts of interest. An investment adviser that is registered or required to be registered under section 203 of the Act must: (1) Evaluate any use or reasonably foreseeable potential use of a covered PO 00000 Frm 00065 Fmt 4701 Sfmt 4702 54023 technology by the investment adviser, or a natural person who is a person associated with the investment adviser, in any investor interaction to identify any conflict of interest associated with that use or potential use (including by testing each such covered technology prior to its implementation or material modification, and periodically thereafter, to determine whether the use of such covered technology is associated with a conflict of interest); (2) Determine if any conflict of interest identified pursuant to paragraph (b)(1) of this section places or results in placing the interest of the investment adviser, or a natural person who is a person associated with the investment adviser, ahead of the interests of investors; and (3) Eliminate, or neutralize the effect of, any conflict of interest (other than conflicts of interest that exist solely because the investment adviser seeks to open a new client account) determined pursuant to paragraph (b)(2) of this section to result in an investor interaction that places the interest of the investment adviser, or a natural person who is a person associated with the investment adviser, ahead of the interests of investors, promptly after the investment adviser determines, or reasonably should have determined, that the conflict of interest placed the interests of the investment adviser, or a natural person who is a person associated with the investment adviser, ahead of the interests of investors. (c) Policies and procedures. An investment adviser that is subject to paragraph (b) of this section and that has any investor interaction using covered technology must adopt and implement written policies and procedures reasonably designed to prevent violations of paragraph (b) of this section, including: (1) A written description of the process for evaluating any use or reasonably foreseeable potential use of a covered technology in any investor interaction pursuant to paragraph (b)(1) of this section and a written description of any material features of, including any conflicts of interest associated with the use of, any covered technology used in any investor interaction prior to such covered technology’s implementation or material modification, which must be updated periodically; (2) A written description of the process for determining whether any conflict of interest identified pursuant to paragraph (b)(1) of this section results in an investor interaction that places the interest of the investment adviser or a natural person who is a person E:\FR\FM\09AUP2.SGM 09AUP2 54024 Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules lotter on DSK11XQN23PROD with PROPOSALS2 associated with the investment adviser ahead of the interests of investors; (3) A written description of the process for determining how to eliminate, or neutralize the effect of, any conflicts of interest determined pursuant to paragraph (b)(2) of this section to result in an investor interaction that places the interest of the investment adviser or natural person VerDate Sep<11>2014 19:26 Aug 08, 2023 Jkt 259001 who is a person associated with the investment adviser ahead of the interests of investors; and (4) A review and written documentation of that review, no less frequently than annually, of the adequacy of the policies and procedures established pursuant to this section and the effectiveness of their implementation as well as a review of PO 00000 Frm 00066 Fmt 4701 Sfmt 9990 the written descriptions established pursuant to this section. By the Commission. Dated: July 26, 2023. Vanessa A. Countryman, Secretary. [FR Doc. 2023–16377 Filed 8–8–23; 8:45 am] BILLING CODE 8011–01–P E:\FR\FM\09AUP2.SGM 09AUP2

Agencies

SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 88, Number 152 (Wednesday, August 9, 2023)]
[Proposed Rules]
[Pages 53960-54024]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2023-16377]



[[Page 53959]]

Vol. 88

Wednesday,

No. 152

August 9, 2023

Part II





Securities and Exchange Commission





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17 CFR Parts 240 and 275





Conflicts of Interest Associated With the Use of Predictive Data 
Analytics by Broker-Dealers and Investment Advisers; Proposed Rule

Federal Register / Vol. 88 , No. 152 / Wednesday, August 9, 2023 / 
Proposed Rules

[[Page 53960]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 275

[Release Nos. 34-97990; IA-6353; File No. S7-12-23]
RIN 3235-AN00; 3235-AN14


Conflicts of Interest Associated With the Use of Predictive Data 
Analytics by Broker-Dealers and Investment Advisers

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'' or 
``SEC'') is proposing new rules (``proposed conflicts rules'') under 
the Securities Exchange Act of 1934 (``Exchange Act'') and the 
Investment Advisers Act of 1940 (``Advisers Act'') 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 Commission is also proposing amendments to rules under the Exchange 
Act and Advisers Act that would require firms to make and maintain 
certain records in accordance with the proposed conflicts rules.

DATES: Comments should be received on or before October 10, 2023.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's internet comment form (https://www.sec.gov/rules/proposed.shtml); or
     Send an email to [email protected]. Please include 
File Number S7-12-23 on the subject line.

Paper Comments

     Send paper comments to Vanessa A. Countryman, Secretary, 
Securities and Exchange Commission, 100 F Street NE, Washington, DC 
20549-1090.

All submissions should refer to File Number S7-12-23. This file number 
should be included on the subject line if email is used. To help the 
Commission process and review your comments more efficiently, please 
use only one method of submission. The Commission will post all 
comments on the Commission's website (https://www.sec.gov/rules/proposed.shtml). Comments are also available for website viewing and 
printing in the Commission's Public Reference Room, 100 F Street NE, 
Washington, DC 20549, on official business days between the hours of 10 
a.m. and 3 p.m. Operating conditions may limit access to the 
Commission's Public Reference Room. Do not include personal 
identifiable information in submissions; you should submit only 
information that you wish to make available publicly. We may redact in 
part or withhold entirely from publication submitted material that is 
obscene or subject to copyright protection.
    Studies, memoranda, or other substantive items may be added by the 
Commission or staff to the comment file during this rulemaking. A 
notification of the inclusion in the comment file of any such materials 
will be made available on the Commission's website. To ensure direct 
electronic receipt of such notifications, sign up through the ``Stay 
Connected'' option at www.sec.gov to receive notifications by email.

FOR FURTHER INFORMATION CONTACT: Blair B. Burnett, Senior Counsel, 
Investment Company Regulation Office, Michael Schrader, Senior Counsel, 
Chief Counsel's Office, Sirimal R. Mukerjee, Senior Special Counsel, 
and Melissa Roverts Harke, Assistant Director, Investment Adviser 
Regulation Office, Division of Investment Management, at (202) 551-6787 
or [email protected], and Kyra Grundeman and James Wintering, Special 
Counsels, Anand Das, Senior Special Counsel, Kelly Shoop, Branch Chief, 
Devin Ryan, Assistant Director, John Fahey, Deputy Chief Counsel, and 
Emily Westerberg Russell, Chief Counsel, Office of Chief Counsel, 
Division of Trading and Markets, at (202) 551-5550 or 
[email protected], Securities and Exchange Commission, 100 F 
Street NE, Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION: The Commission is proposing for public 
comment: 17 CFR 240.15l-2 under the Exchange Act \1\ (``proposed rule 
240.151-2'') and 17 CFR 275.211(h)(2)-4 under the Advisers Act \2\ 
(``proposed rule 275.211(h)(2)-4'' and, together with proposed rule 
240.15l-2, ``proposed conflicts rules''); and amendments to 17 CFR 
240.17a-3 and 17 CFR 240.17a-4 (``rules 17a-3 and 17a-4'') under the 
Exchange Act and 17 CFR 275.204-2 under the Advisers Act (``rule 204-
2'' and, together with the proposed amendments to rules 17a-3 and 17a-
4, ``proposed recordkeeping amendments'').
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    \1\ Unless otherwise noted, when we refer to the Exchange Act, 
we are referring to 15 U.S.C. 78, and when we refer to rules under 
the Exchange Act, we are referring to title 17, part 240 of the Code 
of Federal Regulations [17 CFR 240].
    \2\ Unless otherwise noted, when we refer to the Advisers Act, 
we are referring to 15 U.S.C. 80b, and when we refer to rules under 
the Advisers Act, we are referring to title 17, part 275 of the Code 
of Federal Regulations [17 CFR 275].
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Table of Contents

I. Introduction
    A. Overview
    B. Background
    1. Evolution in the Investment Industry and its Technology Use
    2. Current PDA-Like Technology Use and Expected Growth
    3. Commission Protection of Investors as Technology Has Evolved
    4. Use of Predictive Data Technologies in Investor Interactions
    5. Request for Information and Comment
    C. Overview of the Proposal
II. Discussion
    A. Proposed Conflicts Rules
    1. Scope
    2. Identification, Determination, and Elimination, or 
Neutralization of the Effect of, a Conflict of Interest
    3. Policies and Procedures Requirement
    B. Proposed Recordkeeping Amendments
III. Economic Analysis
    A. Introduction
    B. Broad Economic Considerations
    C. Economic Baseline
    1. Affected Parties
    2. Technology and Market Practices
    3. Regulatory Baseline
    D. Benefits and Costs
    1. Benefits
    2. Costs
    E. Effects on Efficiency, Competition, and Capital Formation
    1. Efficiency
    2. Competition
    3. Capital Formation
    F. Reasonable Alternatives
    1. Expressly Permit, or Require, the Use of Independent Third-
Party Analyses
    2. Require That Senior Firm Personnel and/or Specific Technology 
Subject-Matter Experts Participate in the Process of Adopting and 
Implementing These Policies and Procedures
    3. Provide an Exclusion for Technologies That Consider Large 
Datasets Where Firms Have No Reason To Believe the Dataset Favors 
the Interests of the Firm From the Identification, Evaluation, and 
Testing Requirements
    4. Apply the Requirements of the Proposed Conflicts Rule and 
Proposed Recordkeeping Amendments Only to Broker-Dealer Use of 
Covered Technologies That Have Non-Recommendation Investor 
Interaction
    5. Require That Firms Test Covered Technologies on an Annual 
Basis, or at a Specific Minimum Frequency
    6. Require That Firms Provide a Prescribed and Standardized 
Disclosure
    G. Request for Comment
IV. Paperwork Reduction Act
    A. Introduction
    B. Proposed Conflicts Rules and Proposed Recordkeeping 
Amendments
    C. Request for Comment
V. Initial Regulatory Flexibility Analysis

[[Page 53961]]

    A. Reason for and Objectives of the Proposed Action
    1. Proposed Rules 151-2 and 211(h)(2)-4
    2. Proposed Amendments to Rules 17a-3 and 17a-4 and Rule 204-2
    B. Legal Basis
    C. Small Entities Subject to the Rules and Rule Amendments
    1. Small Advisers Subject to Proposed Rule 211(h)(2)-4 and 
Proposed Amendments to Recordkeeping Rule
    D. Small Broker-Dealers Subject to Proposed Conflicts Rule and 
Amendments to Recordkeeping Rules
    E. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements
    1. Proposed Conflicts Rules
    2. Proposed Amendments to Rule 204-2
    3. Proposed Amendments to Rules 17a-3 and 17a-4
    F. Duplicative, Overlapping, or Conflicting Federal Rules
    1. Proposed Rule 211(h)(2)-4 and Proposed Amendments to Rule 
204-2
    2. Proposed Rule 15l-2 and Proposed Amendments to Rules 17a-3 
and 17a-4
    G. Significant Alternatives
    H. Solicitation of Comments
VI. Consideration of Impact on the Economy
Statutory Authority
Text of Proposed Rules and Form Amendments

I. Introduction

    The adoption and use of newer technologies, such as predictive data 
analytics (``PDA''), by broker-dealers and investment advisers 
(together, ``firms'') have accelerated.\3\ In some instances, firms' 
use of PDA and similar technologies may be subject to statutory or 
regulatory investor protections, but in other cases, it may not. Firms' 
use of PDA-like technologies can bring benefits in market access, 
efficiency, and returns. To the extent that firms are using PDA-like 
technologies to optimize for their own interests in a manner 
(intentionally or unintentionally) that places these interests ahead of 
investor interests, however, investors can suffer harm. Further, due to 
the scalability of these technologies and the potential for firms to 
reach a broad audience at a rapid speed, as discussed below, any 
resulting conflicts of interest could cause harm to investors in a more 
pronounced fashion and on a broader scale than previously possible.\4\
---------------------------------------------------------------------------

    \3\ See Deloitte, Artificial intelligence: The next frontier for 
investment management firms (Feb. 5, 2019), https://www.deloitte.com/global/en/Industries/financial-services/perspectives/ai-next-frontier-in-investment-management.html (``AI is 
providing new opportunities which extend far beyond cost reduction 
and efficient operations. Many investment management firms have 
taken note and are actively testing the waters, applying cognitive 
technologies and AI to various business functions across the 
industry value chain.''); Blake Schmidt and Amanda Albright, AI Is 
Coming for Wealth Management. Here's What That Means, Bloomberg 
Markets (Apr. 21, 2023), https://www.bloomberg.com/news/articles/2023-04-21/vanguard-fidelity-experts-explain-how-ai-is-changing-wealth-management (discussing experts views on AI impact on the 
wealth management industry). As discussed more below, in addition to 
PDA, firms have adopted and used artificial intelligence (``AI''), 
including machine learning, deep learning, neural networks, natural 
language processing (``NLP''), or large language models (including 
generative pre-trained transformers or ``GPT''), as well as other 
technologies that make use of historical or real-time data, lookup 
tables, or correlation matrices (collectively, ``PDA-like 
technologies''). See, e.g., Q. Zhu and J. Luo, Generative Pre-
Trained Transformer for Design Concept Generation: An Exploration, 
Proceedings of the Design Society, Design Vol 2 (May 2022), https://www.cambridge.org/core/journals/proceedings-of-the-design-society/article/generative-pretrained-transformer-for-design-concept-generation-an-exploration/41894D82DCBC0610B5B6E68967B7047F (``GPT 
are language models pre-trained on vast quantities of textual data 
and can perform a wide range of language-related tasks.'') 
(citations omitted).
    \4\ See infra section I.C.
---------------------------------------------------------------------------

    We believe the current regulatory framework should be updated to 
help ensure that firms are appropriately addressing conflicts of 
interests associated with the use of PDA-like technologies. As a 
result, we are proposing specific protections to complement those 
already required under existing regulatory frameworks \5\ to better 
protect investors from harms arising from these conflicts.
---------------------------------------------------------------------------

    \5\ See infra section III.C.3.
---------------------------------------------------------------------------

A. Overview

    Broker-dealers may have a range of conflicts of interest with their 
retail investors.\6\ Likewise, investment advisers may have conflicts 
of interest with respect to advisory clients and investors in their 
pooled investment vehicle clients.\7\ Some of these conflicts of 
interest are inherent to the relationship between these firms and 
investors. For example, an investment adviser that is paid a percentage 
fee based on assets under management has an incentive to encourage a 
client to move assets into his or her advisory account, which could 
conflict with investors' interest, for example, to retain assets in a 
401(k) plan or other retirement account. Similarly, a broker-dealer 
that receives transaction-based (e.g., commission) compensation has an 
incentive to maximize the frequency of transactions, which could 
increase costs to the investor or expose them to other risks associated 
with excess trading.
---------------------------------------------------------------------------

    \6\ While the proposed conflicts rules do not use or define the 
term ``retail investors,'' we use that term in this release to mean 
``a natural person, or the legal representative of such natural 
person, who seeks to receive or receives services primarily for 
personal, family or household purposes,'' which is consistent with 
the definition of ``retail investor'' in Form CRS and would include 
both current and prospective retail customers. See Form CRS, Sec. 
11.E. Separately, we note that, for broker-dealers, the proposed 
conflicts rule defines ``investor'' consistent with the definition 
of ``retail investor'' in Form CRS.
    \7\ Proposed rule 275.211(h)(2)-4 would apply to clients and 
prospective clients of advisers as well as investors and prospective 
investors in pooled investment vehicles advised by those advisers.
---------------------------------------------------------------------------

    Many broker-dealers and investment advisers also have conflicts of 
interest associated with other common business practices. For example, 
some investment product sponsors offer revenue sharing payments, 
creating an incentive for broker-dealers and investment advisers that 
accept such payments to favor those investments. Similarly, firms that 
offer proprietary products have an incentive to favor those products 
over other non-proprietary alternatives. Dual registrant and affiliated 
firms that offer both brokerage and advisory accounts have an incentive 
to steer investors toward the account type that is most profitable for 
the firm, regardless of whether it is in the best interest of the 
investor. Unless adequately addressed, these conflicts of interest can 
cause broker-dealers and investment advisers to place their interests 
ahead of investors' interests.
    Broker-dealers and investment advisers operate within regulatory 
frameworks that in many cases require them to, as applicable, disclose, 
mitigate, or eliminate conflicts.\8\ These regulatory frameworks play a 
fundamental role in protecting retail investors of broker-dealers, 
clients of investment advisers, and investors in pooled investment 
vehicle clients of investment advisers (together, ``investors'') from 
the negative effects of firms placing their own interests ahead of 
investors' interests. As the markets grow and evolve, however, and 
specifically, as firms adopt and utilize newer technologies to interact 
with investors, we are evaluating our regulations' effectiveness in 
protecting investors from the potentially harmful impact of conflicts 
of interest.
---------------------------------------------------------------------------

    \8\ See https://www.sec.gov/rules/final/2019/34-86031.pdf, 
Exchange Act Release No. 86031 (June 5, 2019) [84 FR 33318 (July 12, 
2019)] (``Reg BI Adopting Release''); Commission Interpretation 
Regarding Standard of Conduct for Investment Advisers, Advisers Act 
Release No. 5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)], at 
section II.C. (``Fiduciary Interpretation'') (describing an 
adviser's fiduciary duties to its clients). Additionally, rule 
206(4)-8 under the Advisers Act prohibits certain statements, 
omissions, and other acts, practices, or courses of business as 
fraudulent, deceptive, or manipulative with respect to any investor 
or prospective investor in a pooled investment vehicle.
---------------------------------------------------------------------------

    Recently, firms' adoption and use of PDA-like technologies \9\ have

[[Page 53962]]

accelerated.\10\ While this adoption and use can bring potential 
benefits for firms and investors (e.g., with respect to efficiency of 
operations, which can generate cost savings for investors, or enhancing 
the efficiency of identifying investment opportunities that match an 
investor's preferences, profile, and risk tolerances), they also raise 
the potential for conflicts of interest associated with the use of 
these technologies to cause harm to investors more broadly than 
before.\11\
---------------------------------------------------------------------------

    \9\ Artificial intelligence is generally used to mean the 
capability of a machine to imitate intelligent human behavior and 
machine learning is a subfield of artificial intelligence that gives 
computers the ability to learn without explicitly being programmed. 
See generally Sara Brown, Machine Learning, Explained, MIT Sloan 
School of Management (Apr. 21, 2021), https://mitsloan.mit.edu/ideas-made-to-matter/machine-learning-explained. Predictive data 
analytics draws inferences from large data sets, relying on 
hypothesis-free data mining and inductive reasoning to uncover 
patterns to make predictions about future outcomes, and may use 
natural language processing, signal processing, topic modeling, 
pattern recognition, machine learning, deep learning, neural 
networks, and other advanced statistical methods. See Nathan Cortez, 
Predictive Analytics Law and Policy: Mapping the Terrain: 
Challenging Issues in Specific Private Sector Contexts, 
Substantiating Big Data in Health Care, 14 ISJLP 61, 65 (Fall 2017). 
See generally Financial Industry Regulatory Authority, Inc. 
(``FINRA''), Artificial Intelligence (AI) in the Securities Industry 
5 (June 2020) (``FINRA AI Report''), https://www.finra.org/sites/default/files/2020-06/ai-report-061020.pdf; Financial Stability 
Board, Artificial Intelligence and Machine Learning in Financial 
Services: Market Developments and Financial Stability Implications 
(Nov. 1, 2017) (``FSB AI Report''), https://www.fsb.org/wp-content/uploads/P011117.pdf; see also Department of the Treasury, et al., 
Request for Information and Comment on Financial Institutions' Use 
of Artificial Intelligence, Including Machine Learning (Feb. 2021) 
[86 FR 16837, 16839-40 (Mar. 31, 2021)] (``Treasury RFI'').
    \10\ See infra section I.B.
    \11\ See, e.g., For AI in Asset Management, Tomorrow is Here, 
Markets Media (Mar. 28, 2023), https://www.marketsmedia.com/for-ai-in-asset-management-tomorrow-is-here/ (citing possible benefits for 
investment managers in generating alpha, improving efficiency, 
enhancing product and content distribution, and enhancing risk 
management and customer experience); Christine Schmid, AI in Wealth: 
from Science Fiction to Science Fact, FinExtra (June 8, 2023), 
https://www.finextra.com/blogposting/24323/ai-in-wealth-from-science-fiction-to-science-fact (citing potential benefits in 
personalized portfolio creation, enhanced investor engagement, 
democratized personalized investing, and reduced information 
overload).
---------------------------------------------------------------------------

    While the presence of conflicts of interest between firms and 
investors is not new, firms' increasing use of these PDA-like 
technologies in investor interactions may expose investors to unique 
risks. This includes the risk of conflicts remaining unidentified and 
therefore unaddressed or identified and unaddressed. The effects of 
such unaddressed conflicts may be pernicious, particularly as this 
technology can rapidly transmit or scale conflicted actions across a 
firm's investor base.\12\ For example, conflicts of interest can arise 
from the data the technology uses (including any investor data) and the 
inferences the technology makes (including in analyzing that data, 
other data, securities, or other assets). These issues may render a 
firm's identification of such conflicts for purposes of the firm's 
compliance with applicable Federal securities laws more challenging 
without specific efforts both to fully understand the PDA-like 
technology it is using \13\ and to oversee conflicts that are created 
by or transmitted through its use of such technology.\14\
---------------------------------------------------------------------------

    \12\ See, e.g., Sophia Duffy and Steve Parrish, You Say 
Fiduciary, I Say Binary: A Review and Recommendation of Robo-
Advisors and the Fiduciary and Best Interest Standards, 17 Hastings 
Bus. L.J. 3, at 26 (2021) (stating that the impact of firm conflicts 
of robo-advisors ``are arguably more detrimental than personal 
conflicts between an advisor and client because the number of 
clients impacted by the firm conflict is potentially exponentially 
higher.'') (``Robo-Advisors and the Fiduciary and Best Interest 
Standards'').
    \13\ See, e.g., infra section II.A.2.b and II.A.3 (discussing 
the testing and policies and procedures requirements, respectively, 
of the proposed conflicts rules, which if implemented in accordance 
with the proposal, would necessitate firms' developing an 
understanding of the PDA-like technologies they use).
    \14\ See, e.g., Sohnke M. Bartram, Jurgen Branke & Mehrshad 
Motahari, Artificial Intelligence in Asset Management (2020) (``AI 
in Asset Management'') (``Understanding and explaining the 
inferences made by most AI models is difficult, if not impossible. 
As the complexity of the task or the algorithm grows, opacity can 
render human supervision ineffective, thereby becoming an even more 
significant problem.'').
---------------------------------------------------------------------------

    Moreover, PDA-like technologies may have the capacity to process 
data, scale outcomes from analysis of data, and evolve at rapid 
rates.\15\ While valuable in many circumstances, these technologies 
could rapidly and exponentially scale the transmission of any conflicts 
of interest associated with such technologies to investors.\16\ For 
example, a firm may use PDA-like technologies to automatically develop 
advice and recommendations that are then transmitted to investors 
through the firm's chatbot, push notifications on its mobile trading 
application (``app''), and robo-advisory platform. If the advice or 
recommendation transmitted is tainted by a conflict of interest because 
the algorithm drifted \17\ to advising or recommending investments more 
profitable to the firm or because the dataset underlying the algorithm 
was biased toward investments more profitable to the firm, the 
transmission of this conflicted advice and recommendations could spread 
rapidly to many investors.
---------------------------------------------------------------------------

    \15\ See, e.g., Eray Elicik, Artificial Intelligence vs. Human 
Intelligence: Can a game-changing technology play the game? (Apr. 
20, 2022), https://dataconomy.com/2022/04/is-artificial-intelligence-better-than-human-intelligence/ (``Compared to the 
human brain, machine learning (ML) can process more data and do so 
at a faster rate.''); David Nield, Google Engineers `Mutate' AI to 
Make It Evolve Systems Faster Than We Can Code Them (Apr. 17, 2020), 
https://www.sciencealert.com/coders-mutate-ai-systems-to-make-them-evolve-faster-than-we-can-program-them (``[R]esearchers have tweaked 
[a machine learning system] to incorporate concepts of Darwinian 
evolution and shown it can build AI programs that continue to 
improve upon themselves faster than they would if humans were doing 
the coding.'').
    \16\ See Robo-Advisors and the Fiduciary and Best Interest 
Standards, supra note 12, at 26. See also FINRA AI Report, supra 
note 9 (discussing exploration of the use of AI tools by market 
participants and noting, among other things, that firms should 
ensure sound governance and supervision, including effective means 
of overseeing suitability of recommendations, conflicts of interest, 
customer risk profiles and portfolio rebalancing) (internal 
quotations and citation omitted); Y. Minsky, Communications of the 
ACM, OCaml for the Masses (Sept. 27, 2011), https://dl.acm.org/doi/pdf/10.1145/2018396.2018413 (explaining that ``technology carries 
risk. There is no faster way for a trading firm to destroy itself 
than to deploy a piece of trading software that makes a bad decision 
over and over in a tight loop'' and that the author's employer seeks 
to control these risks by ``put[ting] a very strong focus on 
building software that was easily understood--software that was 
readable.'').
    \17\ See infra note 157 and accompanying text.
---------------------------------------------------------------------------

    Unless adequately addressed, the use of these PDA-like technologies 
may create or transmit conflicts of interest that place a firm's 
interests ahead of investors' interests. This may arise not only when a 
firm is providing investment advice or recommendations, but also in the 
firm's sales practices and investor interactions more generally, such 
as design elements, features, or communications that nudge or prompt 
more immediate and less informed action by the investor.\18\ In light 
of these developments and risks, and for the reasons we describe 
further below, we are proposing that a firm's use of certain PDA-like 
technologies in an investor interaction that places the firm's 
interests ahead of the investors' interests involves a conflict of 
interest that must be eliminated or its effects neutralized in 
accordance with the proposed conflicts rules.
---------------------------------------------------------------------------

    \18\ See, e.g., CFA Institute, Ethics and Artificial 
Intelligence in Investment Management: A Framework for Professionals 
(2022) (stating that professionals should ensure they understand the 
sources of any potential conflicts generated by the use of 
algorithms and work with developers to ensure that such systems do 
not inappropriately incorporate fee considerations in the algorithm 
generating the investment advice).
---------------------------------------------------------------------------

B. Background

1. Evolution in the Investment Industry and Its Technology Use
    Over the last several decades, firms' use of technology to interact 
with investors and provide products and services has evolved 
significantly, and with it, the nature and extent of the conflicts of 
interest this use can create. When Congress first enacted the

[[Page 53963]]

Exchange Act and the Advisers Act, firms were increasingly deploying 
what were then considered advanced technologies, such as punch cards 
and telex machines. As technology improved, firms began adopting other 
technologies, such as computers, email, spreadsheets, and the internet. 
The Commission has previously observed that these and other 
technologies have helped to promote transparency, liquidity, and 
efficiency in our capital markets.\19\ If responsibly implemented and 
overseen by firms, new technologies can aid firms' interactions with 
investors, and bring greater access and product choice, potentially at 
a lower cost, without compromising investor protection, capital 
formation, and fair, orderly, and efficient markets.
---------------------------------------------------------------------------

    \19\ See Interpretation on Use of Electronic Media, Investment 
Company Act Release No. 24426 (Apr. 28, 2000) [65 FR 25843 (May 4, 
2000)], at section I; see also Investment Adviser Marketing, 
Investment Advisers Act No. 5653 (Dec. 22, 2020) [86 FR 13024 (Mar. 
5, 2021)], at section I (``Investment Adviser Marketing Release'') 
(noting that the rules are ``designed to accommodate the continual 
evolution and interplay of technology and advice'').
---------------------------------------------------------------------------

    Where once investors placed trades with their broker in-person, 
they eventually began to place orders over the phone, and then through 
a website. Now investors can instantaneously place a trade directly 
through an app on a smart phone and, instead of a recommendation 
delivered by a human, they may receive push notifications potentially 
designed to affect trading behavior. These technological interactions 
can be designed to respond to human behavior, for example, sending 
increased notifications for certain investment products depending on 
where the person scrolling through investment products pauses on her 
smartphone. As technology continues to evolve, we believe that firms 
are likely to increase their reliance on behavioral science frameworks 
in influencing investor behavior.\20\ Investors that previously met in 
person with their advisers are now able to access computer-generated 
advice that is delivered rapidly in an app to many investors by, for 
example, a robo-adviser. Rather than advertising in local newspapers, 
making cold calls, or relying on referrals, firms are now digitally 
targeting investors.\21\
---------------------------------------------------------------------------

    \20\ See, e.g., Robert W. Cook, President and CEO of FINRA, 
Statement Before the Financial Services Committee U.S. House of 
Representatives (May 6, 2021), https://www.finra.org/media-center/speeches-testimony/statement-financial-services-committee-us-house-representatives (addressing the ``recent trends of retail trading 
platforms is the use of `game-like' and other features that may 
encourage investor behaviors'' and ``the growing prevalence of these 
features''); Margaret Franklin, Investment Gamification: Not All 
Cons, Some Important Pros, Kiplinger (Feb. 20, 2023), https://www.kiplinger.com/investing/investment-gamification-pros-and-cons 
(discussing the use of behavioral techniques and the rising 
influence of social media, and stating that the gamification ``style 
of trading, ushered in largely by the next generation of investors, 
is likely here to stay.''). See also James Tierney, Investment 
Games, 72 Duke L.J. 353, 355 (Nov. 2022) (describing the growth of 
retail investing and discussing gamification, including how ``mobile 
app developers have innovated in user-interface design to compete 
with incumbent brokers [by including features such as] intuitive and 
appealing design, as well as digital engagement practices that 
encourage interaction with the app and that shape the information 
users consider in investing,''); Jill E. Fisch, GameStop and the 
Reemergence of the Retail Investor, 102 B.U. L. Rev. 1799, 1802 
(Oct. 2022) (discussing gamification and the ``evidence that retail 
investment and engagement will both continue and evolve.''); Ernst & 
Young, Social investing: behavioral insights for the modern wealth 
manager (Apr. 2021), https://www.ey.com/en_us/wealth-asset-management/social-investing-behavioral-insights-for-the-modern-wealth-manager (``As firms continue to develop social investing 
operating models, they can use behavioral science frameworks to 
better understand how their client segments are influenced by 
digital design and choice architecture[.]'').
    \21\ See, e.g., Disclosure Innovations in Advertising and Other 
Communications with the Public, FINRA Regulatory Notice 19-31 (Sept. 
19, 2019), https://www.finra.org/rules-guidance/notices/19-31; see 
also Leslie K. John, Tami Kim, and Kate Barasz, Ads that Don't 
Overstep, Harvard Bus. Rev. (Jan.- Feb. 2018), https://hbr.org/2018/01/ads-that-dont-overstep.
---------------------------------------------------------------------------

    In recent years, we have observed a rapid expansion in firms' 
reliance on technology and technology-based products and services.\22\ 
The use of technology is now central to how firms provide their 
products and services to investors.\23\ Some firms and investors in 
financial markets now use new technologies such as AI, machine 
learning, NLP, and chatbot technologies to make investment decisions 
and communicate between firms and investors.\24\ In addition, existing 
technologies for data-analytics and data collection continue to improve 
and find new applications.\25\
---------------------------------------------------------------------------

    \22\ See generally Marc Andreessen, Why Software Is Eating the 
World, Wall St. J. (Aug. 20, 2011), https://www.wsj.com/articles/SB10001424053111903480904576512250915629460 (discussing, among other 
things, the transformation of the financial services industry by 
software over the last 30 years) (``Why Software is Eating the 
World''); Robo-Advisors and the Fiduciary and Best Interest 
Standards, supra note 12, at 4 (stating that ``[o]ver the past 
decade, robo-advisors, or automated systems for providing financial 
advice and services, are becoming more and more popular'' and 
discussing estimated growth); Nicole G. Iannarone, Fintech's 
Promises and Perils Computer as Confidant: Digital Investment Advice 
and the Fiduciary Standard, 93 Chi.-Kent L. Rev. 141, 141 (2018) 
(``Automated investment advisers permeate the investment industry. 
Digital investment advisers are the fastest growing segment of 
financial technology (FinTech) and are disrupting traditional 
investment advisory delivery models.'') (citations omitted).
    \23\ See, e.g., Investment Adviser Marketing Release, supra note 
19, at section I (``The concerns that motivated the Commission to 
adopt the advertising and solicitation rules [in 1961 and 1979, 
respectively] still exist today, but investment adviser marketing 
has evolved with advances in technology. In the decades since the 
adoption of both the advertising and solicitation rules, the use of 
the internet, mobile applications, and social media has become an 
integral part of business communications. Consumers today often rely 
on these forms of communication to obtain information, including 
reviews and referrals, when considering buying goods and services. 
Advisers and third parties also rely on these same types of outlets 
to attract and refer potential customers.''); FINRA Investor 
Education Foundation, Investors in the United States: The Changing 
Landscape (Dec. 2022) https://www.finrafoundation.org/sites/finrafoundation/files/NFCS-Investor-Report-Changing-Landscape.pdf 
(discussing, among others, website and mobile app use for placing 
trades and use of social media sites for obtaining investment 
information).
    \24\ Michael Kearns & Yuriy Nevmyvaka Machine Learning for 
Market Microstructure and High Frequency Trading, High Frequency 
Trading--New Realities for Traders, Markets and Regulators (David 
Easley, Marcos Lopez de Prado & Maureen O'Hara editors, Risk Books, 
2013); see also Christian Thier & Daniel dos Santos Monteiro, How 
Much Artificial Intelligence Do Robo-Advisors Really Use? (Aug. 31, 
2022), https://ssrn.com/abstract=4218181; Imani Moise, Bond 
Investing Gets the Robo-Adviser Treatment, The Wall Street Journal 
(June 7, 2023), https://www.wsj.com/articles/buying-bonds-is-hard-heres-a-way-to-let-a-robot-do-it-70a4587b.
    \25\ Natasha Lekh & Petr P[aacute]tek, What's the Future of Web 
Scraping in 2023?, APIFY Blog (Jan. 20, 2023), https://blog.apify.com/future-of-web-scraping-in-2023/; Jon Martindale, Best 
Apps to Use GPT-4, Digitaltrends (May 4, 2023), https://www.digitaltrends.com/computing/best-apps-to-use-gpt-4/.
---------------------------------------------------------------------------

2. Current PDA-Like Technology Use and Expected Growth

    Financial market participants currently use AI and machine learning 
technologies in a variety of ways. For example, algorithmic trading is 
a widely used application of machine learning in finance, where 
machine-learning models analyze large datasets and identify patterns 
and signals to optimize for, predict, guide, forecast, or direct 
investment-related behaviors or outcomes.\26\ Moreover, the advent and 
growth of services available on certain digital platforms, such as 
those offered by online brokerages and robo-advisers, have multiplied 
the opportunities for retail investors, in particular, to invest and 
trade in securities, and in small amounts through fractional 
shares.\27\

[[Page 53964]]

This increased accessibility has been one of the key factors associated 
with the increase of retail investor participation in U.S. securities 
markets in recent years.\28\ Firms have also expanded their use of 
technology to include ``digital engagement practices'' or ``DEPs,'' 
such as behavioral prompts, differential marketing, game-like features 
(commonly referred to as ``gamification''), and other design elements 
or features designed to engage retail investors when using a firm's 
digital platforms (e.g., website, portal, app) \29\ for services such 
as trading, robo-advice, and financial education. Our staff has 
observed that firms use technology to more efficiently develop 
investment strategies, including by using technology to automate their 
services, and to analyze the success of specific features and marketing 
practices at influencing retail investor behavior.\30\ Firms may also 
seek to lower expenses by replacing customer service personnel with 
chatbots that can address common customer questions, and outsourcing 
their back office operations to vendors that rely heavily on 
technology.\31\
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    \26\ See generally Alessio Azzutti, Wolf-Goerge Ringe, H. 
Siegfried Stiehl, Machine Learning, Market Manipulation, and 
Collusion on Capital Markets: Why the ``Black Box'' Matters, 43 U. 
Pa. J. Int'l L. 1 (2021), https://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=2035&context=jil (``Machine Learning and 
Market Manipulation'') (discussing current uses of algorithmic 
trading and exploring the risks to market integrity in connection 
with the evolving uses of artificial intelligence in algorithmic 
trading).
    \27\ See, e.g., Nolan Schloneger, A Case for Regulating Gamified 
Investing, 56 Ind. L. Rev. 175 (2022) (``Th[e] rise [of investing 
applications] is largely attributed to zero commission and 
fractional-share trading.''); John Csiszar, How Our Approach to 
Investing Has Changed Forever, YAHOO! (Mar. 10, 2021), https://www.yahoo.com/now/approach-investing-changed-forever-190007929.html 
(``Fractional share trading is just in its infancy but appears well 
on its way to changing how consumers approach investing. With 
fractional share trading, you can invest any dollar amount into 
stock, even if you don't have enough to buy a single share . . . . 
Fractional share investing allows nearly anyone to get involved in 
the stock market without needing $100,000 or more to buy a properly 
diversified portfolio of individual stock names.''). See also 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 (``Some brokers 
have sought to attract new customers by offering the ability to 
purchase fractional shares. Fractional shares give investors the 
ability to purchase less than 1 share of a stock.''). Any staff 
statements represent the views of the staff. They are not a rule, 
regulation, or statement of the Commission. Furthermore, the 
Commission has neither approved nor disapproved their content. These 
staff statements, like all staff statements, have no legal force or 
effect: they do not alter or amend applicable law; and they create 
no new or additional obligations for any person.
    \28\ See, e.g., Maggie Fitzgerald, Retail Investors Continue to 
Jump Into the Stock Market After GameStop Mania, CNBC (Mar. 10, 
2021), https://www.cnbc.com/2021/03/10/retail-investor-ranks-in-the-stock-market-continue-to-surge.html (providing year-over-year app 
download statistics for Robinhood, Webull, Sofi, Coinbase, TD 
Ameritrade, Charles Schwab, E-Trade, and Fidelity from 2018-2020, 
and monthly figures for January and February of 2021); John 
Gittelsohn, Schwab Boosts New Trading Accounts 31% After Fees Go to 
Zero, Bloomberg (Nov. 14, 2019), https://www.bloomberg.com/news/articles/2019-11-14/schwab-boosts-brokerage-accounts-by-31-after-fees-cut-to-zero (noting that Charles Schwab opened 142,000 new 
trading accounts in October, a 31% jump over September's pace).
    \29\ Examples of DEPs include the following: social networking 
tools; games, streaks and other contests with prizes; points, 
badges, and leaderboards; notifications; celebrations for trading; 
visual cues; ideas presented at order placement and other curated 
lists or features; subscriptions and membership tiers; and chatbots.
    \30\ See, e.g., SEC Investor Bulletin: Robo-Advisers (Feb. 23, 
2017), https://www.sec.gov/oiea/investor-alerts-bulletins/ib_robo-advisers (discussing automated digital investment advisory 
programs); see also FINRA AI Report, supra note 9 (discussing three 
areas where broker-dealers are evaluating or using AI in the 
securities industry: communications with customers, investment 
processes, and operational functions).
    \31\ See, e.g., SS&C Gets Automation Rolling with 180 `Digital 
Workers', Ignites (Feb. 9, 2023), https://www.ignites.com/c/3928224/508304?referrer_module=searchSubFromIG&highlight=SS&C.
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    The rate at which PDA-like technologies continues to evolve is 
increasing \32\ and firms are exploring and deploying AI-based 
applications across different functions of their organizations, 
including customer facing, investment, and operational activities.\33\ 
These PDA-like technologies are complex and may include several 
categories of machine learning \34\ algorithms, such as deep 
learning,\35\ supervised learning,\36\ unsupervised learning,\37\ and 
reinforcement learning \38\ processes.\39\ In the past few years, these 
PDA-like technologies have made increasing use of natural language 
processing and natural language generation.\40\ For example, AI has 
revolutionized chatbots by enabling them to understand and respond to 
natural language more accurately and learn and improve responses over 
time, leading to more personalized interactions with users. Recently, a 
new wave of online chatbots has rapidly moved machines using AI into 
new territory.\41\ Some of these chatbots have passed what is known as 
the ``Turing test'' and have become virtually indistinguishable from 
humans in particular situations.\42\ AI use is increasing year over 
year and in an array of applications.\43\ For instance, some robo-
advisers use chatbots and NLP technology for their online platforms to 
provide investment advice and manage investment portfolios.\44\ These 
platforms may use a combination of AI, machine learning, NLP, and 
chatbot technologies to provide personalized investment recommendations 
to customers based on customer risk tolerance and investment goals.
---------------------------------------------------------------------------

    \32\ See, e.g., Robin Feldman and Kara Stein, AI Governance in 
the Financial Industry, 27 Stan. J.L. Bus. & Fin. 94, 122 (2022) 
(describing AI as ``a technology that is rapidly evolving and 
capable of learning.'').
    \33\ See, e.g., Merav Ozair, FinanceGPT: The Next Generation of 
AI-Powered Robo Advisors and Chatbots (June 27, 2023), https://www.nasdaq.com/articles/financegpt-the-next-generation-of-ai-powered-robo-advisors-and-chatbots (describing current uses and 
development) (``FinanceGPT'').
    \34\ FINRA described ``Machine Learning (ML)'' as ``a field of 
computer science that uses algorithms to process large amounts of 
data and learn from it. Unlike traditional rules-based programming, 
[machine learning] models learn from input data to make predictions 
or identify meaningful patterns without being explicitly programmed 
to do so. There are different types of [machine-learning] models, 
depending on their intended function and structure[.]'' See FINRA AI 
Report, supra note 9.
    \35\ FINRA described a ``deep learning model'' as a model 
``built on an artificial neural network, in which algorithms process 
large amounts of unlabeled or unstructured data through multiple 
layers of learning in a manner inspired by how neural networks 
function in the brain. These models are typically used when the 
underlying data is significantly large in volume, obtained from 
disparate sources, and may have different formats (e.g., text, 
voice, and video).'' See id.
    \36\ FINRA described a ``supervised machine learning'' as a 
model that ``is trained with labeled input data that correlates to a 
specified output. . . . The model is continuously refined to provide 
more accurate output as additional training data becomes available. 
After the model has learned from the patterns in the training data, 
it can then analyze additional data to produce the desired output . 
. . .'' See id.
    \37\ As described by FINRA, in unsupervised machine learning, 
``the input data is not labeled nor is the output specified. 
Instead, the models are fed large amounts of raw data and the 
algorithms are designed to identify any underlying meaningful 
patterns. The algorithms may cluster similar data but do so without 
any preconceived notion of the output . . . .'' See id.
    \38\ As described by FINRA, in reinforcement learning, ``the 
model learns dynamically to achieve the desired output through trial 
and error. If the model algorithm performs correctly and achieves 
the intended output, it is rewarded. Conversely, if it does not 
produce the desired output, it is penalized. Accordingly, the model 
learns over time to perform in a way that maximizes the net reward . 
. . .'' See id.
    \39\ See also FSB AI Report, supra note 9; Treasury RFI, supra 
note 9.
    \40\ See, e.g., FINRA AI Report, supra note 9.
    \41\ See Cade Metz, How Smart Are the Robots Getting?, The New 
York Times (Jan. 20, 2023, updated Jan. 25, 2023).
    \42\ Id. The Turing test is a subjective test determined by 
whether the person interacting with a machine believes that they are 
interacting with another person. See id.
    \43\ Embracing the Rapid Pace of AI, MIT Technology Review 
Insights (May 19, 2021), https://www.technologyreview.com/2021/05/19/1025016/embracing-the-rapid-pace-of-ai/.
    \44\ See, e.g., FinanceGPT, supra note 33 (describing current 
uses and development).
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    As a result of a growing desire to perform functions remotely and 
through automated means, the COVID-19 pandemic accelerated the adoption 
of certain PDA-like technologies.\45\ Many

[[Page 53965]]

expect this momentum to continue, with AI becoming a mainstream 
technology across many industries, including the financial sector.\46\ 
Organizations, including firms in the securities industry,\47\ are 
using AI in a multitude of ways, including responding to customer 
inquiries, automating back-office processes, quality control,\48\ risk 
management, client identification and monitoring, selection of trading 
algorithms, and portfolio management.\49\ Others are actively 
developing investment advisory services based on PDA-like 
technologies.\50\ Further, recent advancements in data collection 
techniques have significantly enhanced the scale and scope of data 
analytics, and its potential applications. Due to increases in 
processing power and data storage capacity, a vast amount of data is 
now available for high-speed analysis using these technologies.\51\ 
Furthermore, the range of data types has also expanded, with consumer 
shopping histories, media preferences, and online behavior now among 
the many types of data that data analytics can use to synthesize 
information, forecast financial outcomes, and predict investor and 
customer behavior.\52\ Consequently, these technologies can be applied 
in novel and powerful ways which may be subtle, such as using the 
layout of an app and choice of data presentation and formatting to 
influence trading decisions.\53\ Some trading apps use PDA and AI/
machine learning along with detailed user data to increase user 
engagement and trading activity.\54\
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    \45\ See, e.g., Joe McKendrick, AI Adoption Skyrocketed Over the 
Last 18 Months, Harvard Bus. Rev. (Sept. 27, 2021), https://hbr.org/2021/09/ai-adoption-skyrocketed-over-the-last-18-months (``The 
[COVID-19] crisis accelerated the adoption of analytics and AI, and 
this momentum will continue into the 2020s, surveys show. Fifty-two 
percent of companies accelerated their AI adoption plans because of 
the Covid crisis, a study by PwC finds. Just about all, 86%, say 
that AI is becoming a `mainstream technology' at their company in 
2021. Harris Poll, working with Appen, found that 55% of companies 
reported they accelerated their AI strategy in 2020 due to Covid, 
and 67% expect to further accelerate their AI strategy in 2021.''); 
KPMG, Thriving in an AI World: Unlocking the Value of AI Across 
Seven Key Industries (May 2021), at 5, https://advisory.kpmg.us/articles/2021/thriving-in-an-ai-world.html (``Thriving in an AI 
World''); Blake Schmidt and Amanda Albright, AI Is Coming for Wealth 
Management. Here's What That Means, Bloomberg Markets (Apr. 21, 
2023), https://www.bloomberg.com/news/articles/2023-04-21/vanguard-fidelity-experts-explain-how-ai-is-changing-wealth-management 
(discussing experts views on AI impact on the wealth management 
industry).
    \46\ Id.
    \47\ See IOSCO, The use of artificial intelligence and machine 
learning by market intermediaries and asset managers (Sept. 2021), 
at 1 (``IOSCO AI/ML Report''), iosco.org/library/pubdocs/pdf/IOSCOPD684.pdf (``Artificial Intelligence (AI) and Machine Learning 
(ML) are increasingly used in financial services, due to a 
combination of increased data availability and computing power. The 
use of AI and ML by market intermediaries and asset managers may be 
altering firms' business models.'').
    \48\ See Thriving in an AI World, supra note 45; see also FINRA 
AI Report, supra note 9, at 5-10 (noting the use of AI in the 
securities industry for communications with customers, investment 
processes, and operational functions); FINRA, Deep Learning: The 
Future of the Market Manipulation Surveillance Program https://www.finra.org/media-center/finra-unscripted/deep-learning-market-surveillance (``FINRA's Market Regulation and Technology teams 
recently wrapped up an extensive project to migrate the majority of 
FINRA's market manipulation surveillance program to using deep 
learning in what is perhaps the largest application of artificial 
intelligence in the RegTech space to date.''); Machine Learning and 
Market Manipulation, supra note 26; IOSCO AI/ML Report, id.
    \49\ IOSCO AI/ML Report, supra note 47.
    \50\ See, e.g., Hugh Son, JPMorgan is developing a ChatGPT-like 
A.I. service that gives investment advice, CNBC (May 25, 2023), 
https://www.cnbc.com/2023/05/25/jpmorgan-develops-ai-investment-advisor.html (discussing a trademark application filed by JPMorgan 
for a product called IndexGPT that will utilize ``cloud computing 
software using artificial intelligence'' for ``analyzing and 
selecting securities tailored to customer needs[.]'').
    \51\ See, e.g., Dimitris Andriosopoulos et al., Computational 
Approaches and Data Analytics in Financial Services: A Literature 
Review, 70 J. Operational Rsch. Soc. 1581 (2019), https://doi.org/10.1080/01605682.2019.1595193; James Lawler & Anthony Joseph, Big 
Data Analytics Methodology in the Financial Industry, 15 Info. Sys. 
Ed. J. 38 (July 2017), https://isedj.org/2017-15/n4/ISEDJv15n4p38.html.
    \52\ Daniel Broby, The Use of Predictive Analytics in Finance, 8 
J. Fin & Data Sci. 145 (Nov. 2022), https://doi.org/10.1016/j.jfds.2022.05.003; OECD, Artificial Intelligence, Machine Learning 
and Big Data in Finance: Opportunities, Challenges, and Implications 
for Policy Makers (2021), https://www.oecd.org/finance/financial-markets/Artificial-intelligence-machine-learning-big-data-in-finance.pdf.
    \53\ See, e.g., Sayan Chaudhury and Chinmay Kulkarni, Design 
Patterns of Investing Apps and Their Effects on Investing Behaviors 
(2021) (``Chaudhury & Kulkarni''), dl.acm.org/doi/fullHtml/10.1145/3461778.3462008 (``investing apps can be considered as technical and 
social choice architectures that influence investing behavior'').
    \54\ See, e.g., Alex McFarland, 10 ``Best'' AI Stock Trading 
Bots, Unite.AI (June 4, 2023), https://www.unite.ai/stock-trading-bots/.
---------------------------------------------------------------------------

    Any risks of conflicts of interest associated with AI use will 
expand as firms' use of AI grows. These risks will have broad 
consequences if AI makes decisions that favor the firms' interests and 
then rapidly deploys that information to investors, potentially on a 
large scale.\55\ Firms' nascent use of AI may already be exposing 
investors to these types of risks as well as others.\56\ We are 
concerned that firms will intentionally or unintentionally take their 
own interest into account in the data or software underlying the 
applicable AI, as well as the applicable PDA-like technologies, 
resulting in investor harm. Among other things, a firm may use these 
technologies to optimize for the firm's revenue or to generate 
behavioral prompts or social engineering to change investor behavior in 
a manner that benefits the firm but is to the detriment of the 
investor.
---------------------------------------------------------------------------

    \55\ See, e.g., Robo-Advisors and the Fiduciary and Best 
Interest Standards, supra note 12 (stating that the impact of firm 
conflicts of robo-advisors ``are arguably more detrimental than 
personal conflicts between an advisor and client because the number 
of clients impacted by the firm conflict is potentially 
exponentially higher.''). See also AI in Asset Management, supra 
note 14 (``AI can make wrong decisions based on incorrect inferences 
that have captured spurious or irrelevant patterns in the data. For 
example, ANNs [artificial neural networks] that are trained to pick 
stocks with high expected returns might select illiquid, distressed 
stocks.''); FINRA AI Report, supra note 9, at 11-19 (noting that the 
use of AI ``raises several concerns that may be wide-ranging across 
various industries as well as some specific to the securities 
industry. Over the past few years, there have been numerous 
incidents reported about AI applications that may have been 
fraudulent, nefarious, discriminatory, or unfair, highlighting the 
issue of ethics in AI applications.''); FINRA AI Report, supra note 
9, at 13 (``Depending on the use case, data scarcity may limit the 
model's analysis and outcomes, and could produce results that may be 
narrow and irrelevant. On the other hand, incorporating data from 
many different sources may introduce newer risks if the data is not 
tested and validated, particularly if new data points fall outside 
of the dataset used to train the model.'').
    \56\ See, e.g., FINRA AI Report, supra note 9, at 5 (``The use 
of AI-based applications is proliferating in the securities 
industry[.]''); Sophia Duffy and Steve Parrish, You Say Fiduciary, I 
Say Binary: A Review and Recommendation of Robo-Advisors and the 
Fiduciary and Best Interest Standards, 17 Hastings Bus. L.J. 3, at 
26 (2021) (``robo-advisors can be, and often are, intentionally 
programmed to favor the institution by making recommendations that 
favor the institution's products, rebalance client portfolios in 
ways which will allow the institution to earn more fees, and 
otherwise make recommendations that benefit the firm'').
---------------------------------------------------------------------------

3. Commission Protection of Investors as Technology Has Evolved
    As noted above, firms' use of technology and subsequent adaptation 
incorporating emerging technologies are not new.\57\ At the same time, 
the Commission has addressed firms' relationships with investors in a 
variety of ways to ensure investor protection as use of technology in 
those relationships has evolved over time.\58\ The proposal, thus, is 
consistent with the Commission's practice of evolving our regulation in 
light of market and technological developments.
---------------------------------------------------------------------------

    \57\ See supra section I.B.2.
    \58\ See infra note 114.
---------------------------------------------------------------------------

    Broker-dealers and investment advisers are currently subject to 
extensive obligations under Federal securities laws and regulations, 
and, in the case of broker-dealers, rules of self-regulatory 
organizations,\59\ that are

[[Page 53966]]

designed to promote conduct that, among other things, protects 
investors, including protecting investors from conflicts of 
interest.\60\ To the extent PDA-like technologies are used in investor 
interactions that are subject to existing obligations, those 
obligations apply. These obligations include, but are not limited to, 
obligations related to investment advice and recommendations; \61\ 
general and specific requirements aimed at addressing certain conflicts 
of interest, including requirements to eliminate, mitigate, or disclose 
certain conflicts of interest; disclosure of firms' services, fees, and 
costs; disclosure of certain business practices, advertising, 
communications with the public (including the use of ``investment 
analysis tools''); supervision; and obligations related to policies and 
procedures.\62\ In addition to these obligations, Federal securities 
laws and regulations broadly prohibit fraud by broker-dealers and 
investment advisers as well as fraud by any person in the offer, 
purchase, or sale of securities, or in connection with the purchase or 
sale of securities.
---------------------------------------------------------------------------

    \59\ Any person operating as a ``broker'' or ``dealer'' in the 
U.S. securities markets must register with the Commission, absent an 
exception or exemption. See Exchange Act section 15(a), 15 U.S.C. 
78o(a); see also Exchange Act sections 3(a)(4) and 3(a)(5), 15 
U.S.C. 78c(a)(4) and 78c(a)(5) (definitions of ``broker'' and 
``dealer,'' respectively). Generally, all registered broker-dealers 
that deal with the public must become members of FINRA, a registered 
national securities association, unless the broker or dealer effects 
transactions in securities solely on an exchange of which it is a 
member. See Exchange Act section 15(b)(8), 15 U.S.C. 78o(b)(8); see 
also 17 CFR 240.15b9-1 (providing an exemption from Section 
15(b)(8)). FINRA is the sole national securities association 
registered with the SEC under Section 15A of the Exchange Act. 
Because this release is focused on broker-dealers that deal with the 
public and are FINRA member firms (unless an exception applies), we 
refer to FINRA rules as broadly applying to ``broker-dealers,'' 
rather than to ``FINRA member firms.''
    \60\ See infra section III.C.3; Fiduciary Interpretation, supra 
note 8, at section II.C. (``The duty of loyalty requires that an 
adviser not subordinate its clients' interests to its own.''); see 
also Reg BI Adopting Release, supra note 8, at section II.A.1. (The 
``without placing the financial or other interest . . . ahead of the 
interest of the retail customer'' phrasing recognizes that while a 
broker-dealer will inevitably have some financial interest in a 
recommendation--the nature and magnitude of which will vary--the 
broker-dealer's interests cannot be placed ahead of the retail 
customer's interest''). Additionally, broker-dealers often provide a 
range of services that do not involve a recommendation to a retail 
customer--which is required in order for Reg BI to apply--and those 
services are subject to general and specific requirements to address 
associated conflicts of interest under the Exchange Act, Securities 
Act of 1933, and relevant self-regulatory organization (``SRO'') 
rules as applicable. See also FINRA Report on Conflicts of Interest 
(Oct. 2013), at Appendix I (Conflicts Regulation in the United 
States and Selected International Jurisdictions) (``FINRA Conflict 
Report''), https://www.finra.org/sites/default/files/Industry/p359971.pdf (describing broad obligations under SEC and FINRA rules 
as well as specific conflicts-related disclosure requirements under 
FINRA rules).
    \61\ See, e.g., 17 CFR 240.15l-1(a)(1) (``Exchange Act rule 15l-
1(a)(1)'') (requiring broker-dealers and their associated persons to 
act in the best interest of retail customers when making 
recommendations, without placing the financial or other interest of 
the broker-dealer or its associated person ahead of the interest of 
the retail customer).
    \62\ Compliance with the proposed conflicts rules would not 
alter a broker-dealer's or investment adviser's existing obligations 
under the Federal securities laws. The proposed conflicts rules 
would apply in addition to any other obligations under the Exchange 
Act and Advisers Act, along with any rules the Commission may adopt 
thereunder, and any other applicable provisions of the Federal 
securities laws and related rules and regulations.
---------------------------------------------------------------------------

    The Commission has long acted to protect investors against the harm 
that can come when a firm acts on its conflicts of interest.\63\ For 
example, the Commission has brought enforcement actions regarding an 
investment adviser's fiduciary duty to its clients with respect to 
conflicts of interest.\64\ Similarly, the Commission has reinforced 
fraud protection for investors in pooled investment vehicles against 
conflicts of interest through rule 206(4)-8.\65\ The Commission 
regulates investment adviser advertising and marketing practices to 
protect against, among others, adviser conflicts of interest that may 
taint such marketing, including through recent amendments adapting 
those protections in light of the evolution of practices and 
technologies.\66\
---------------------------------------------------------------------------

    \63\ See infra section III.C.
    \64\ See, e.g., SEC Press Release, SEC Share Class Initiative 
Returning More Than $125 Million to Investors: Reflecting SEC's 
Commitment to Retail Investors, 79 Investment Advisers Who Self-
Reported Advisers Act Violations Agree to Compensate Investors 
Promptly, Ensure Adequate Fee Disclosures (Mar. 11, 2019), https://www.sec.gov/news/press-release/2019-28 (describing settled orders 
against 79 investment advisers finding that the settling investment 
advisers placed their clients in mutual fund share classes that 
charged 12b-1 fees when lower-cost share classes of the same fund 
were available to their clients without adequately disclosing that 
the higher cost share class would be selected; according to the 
SEC's orders, the 12b-1 fees were routinely paid to the investment 
advisers in their capacity as brokers, to their broker-dealer 
affiliates, or to their personnel who were also registered 
representatives, creating a conflict of interest with their clients, 
as the investment advisers stood to benefit from the clients' paying 
higher fees); SEC v. Sergei Polevikov, et al., Litigation Release 
No. 25475 (Aug. 17, 2022) (settled order) (final judgment against 
employee working as a quantitative analyst at two asset management 
firms ``for perpetrating a front-running scheme that generated 
profits of approximately $8.5 million''); SEC Brings Settled Actions 
Charging Cherry-Picking and Compliance Failures, Adm. Proc. File No. 
3-20955 (Aug 10, 2022) (settled order) (alleged multi-year cherry-
picking scheme of former investment adviser representative of 
registered investment adviser preferentially allocating profitable 
trades or failing to allocate unprofitable trades to a adviser's 
personal accounts at the expense of the advisers client accounts).
    \65\ 17 CFR 275.206(4)-8; see, e.g., In re. Virtua Capital 
Management, LLC, et al., Advisers Act Release No. 6033 (May 23, 
2022) (allegedly failing to disclose conflicts of interest and 
associated fees, and breaching fiduciary duty to multiple private 
investment funds) (settled order).
    \66\ See Investment Adviser Marketing Release, supra note 19, at 
section I (``The concerns that motivated the Commission to adopt the 
advertising and solicitation rules [in 1961 and 1979, respectively] 
still exist today, but investment adviser marketing has evolved with 
advances in technology. In the decades since the adoption of both 
the advertising and solicitation rules, the use of the internet, 
mobile applications, and social media has become an integral part of 
business communications. Consumers today often rely on these forms 
of communication to obtain information, including reviews and 
referrals, when considering buying goods and services. Advisers and 
third parties also rely on these same types of outlets to attract 
and refer potential customers.'').
---------------------------------------------------------------------------

    Likewise, broker-dealers have long been subject to Commission and 
SRO regulations and rules that govern their business conduct, including 
general and specific obligations to address conflicts of interest.\67\ 
For example, under existing antifraud provisions of the Exchange Act, a 
broker-dealer has a duty to disclose material adverse information to 
its customers.\68\ Indeed, the Commission has enforced a broker-
dealer's duty to disclose material conflicts of interest under the 
antifraud provisions.\69\ Broker-dealers are subject to specific FINRA 
rules aimed at addressing certain conflicts of interest.\70\ Moreover, 
in 2019 the Commission adopted Regulation Best Interest (``Reg BI''), 
which was designed to enhance the quality of broker-dealer 
recommendations to retail customers and reduce the potential harm to 
retail customers that may be caused by conflicts of interest,\71\ by 
requiring broker-dealers that make recommendations to retail customers 
to, among other things, establish, maintain, and enforce policies and 
procedures reasonably designed to identify and

[[Page 53967]]

disclose, mitigate, or eliminate, conflicts associated with a 
recommendation, including conflicts of interest that may result through 
the use of PDA-like technology to make recommendations (Reg BI's 
``Conflict of Interest Obligation'').\72\
---------------------------------------------------------------------------

    \67\ See infra section III.C.3
    \68\ A broker-dealer may be liable if it does not disclose 
``material adverse facts of which it is aware.'' See, e.g., Chasins 
v. Smith, Barney & Co., 438 F.2d 1167, 1172 (2nd Cir. 1970); SEC v. 
Hasho, 784 F. Supp. 1059, 1110 (S.D.N.Y. 1992); In the Matter of 
RichMark Capital Corp., Exchange Act Release No. 48758 (Nov. 7, 
2003) (Commission Opinion) (``When a securities dealer recommends 
stock to a customer, it is not only obligated to avoid affirmative 
misstatements, but also must disclose material adverse facts of 
which it is aware. That includes disclosure of `adverse interests' 
such as `economic self-interest' that could have influenced its 
recommendation.'') (citations omitted).
    \69\ See, e.g., In re. Edward D. Jones & Co, Securities Act 
Release No. 8520 (Dec. 22, 2004) (settled order) (broker-dealer 
violated antifraud provisions of Securities Act and Exchange Act by 
failing to disclose conflicts of interest arising from receipt of 
revenue sharing, directed brokerage payments and other payments from 
``preferred'' families that were exclusively promoted by broker-
dealer); In re. Morgan Stanley DW Inc., Securities Act Release No. 
8339 (Nov. 17, 2003) (settled order) (broker-dealer violated 
antifraud provisions of Securities Act by failing to disclose 
special promotion of funds from families that paid revenue sharing 
and portfolio brokerage).
    \70\ FINRA rules establish restrictions on the use of non-cash 
compensation in connection with the sale and distribution of mutual 
funds, variable annuities, direct participation program securities, 
public offerings of debt and equity securities, investment company 
securities, real estate investment trust programs, and the use of 
non-cash compensation to influence or reward employees of others. 
See FINRA Rules 2310, 2320, 2331, 2341, 5110, and 3220. These rules 
generally limit the manner in which members can pay or accept non-
cash compensation and detail the types of non-cash compensation that 
are permissible.
    \71\ See Reg BI Adopting Release supra note 8, at text 
accompanying n.21.
    \72\ 17 CFR 240.15l-1(a)(2)(iii) (``Exchange Act rule 15l-
1(a)(2)(iii)'').
---------------------------------------------------------------------------

    The Commission has and will continue to bring enforcement actions 
for violations of the Federal securities laws that entail the use of 
PDA-like technologies. However, the rapid acceleration of PDA-like 
technologies and their adoption in the investment industry,\73\ the 
additional challenges associated with identifying and addressing 
conflicts of interest resulting from the use of these new technologies, 
and the concerns relating to scalability, discussed above, reinforce 
the importance of ensuring our regulatory regime specifically addresses 
these issues. In particular, disclosure may be ineffective in light of, 
as discussed above, the rate of investor interactions, the size of the 
datasets, the complexity of the algorithms on which the PDA-like 
technology is based, and the ability of the technology to learn 
investor preferences or behavior, which could entail providing 
disclosure that is lengthy, highly technical, and variable, which could 
cause investors difficulty in understanding the disclosure.
---------------------------------------------------------------------------

    \73\ See, e.g., Amy Caiazza, Rob Rosenblum, and Danielle 
Sartain, Investment Advisers' Fiduciary Duties: The Use of 
Artificial Intelligence, Harvard Law School Forum on Corporate 
Governance (June 11, 2020), https://corpgov.law.harvard.edu/2020/06/11/investment-advisers-fiduciary-duties-the-use-of-artificial-intelligence/ (``Artificial intelligence (AI) is an increasingly 
important technology within the investment management industry.''); 
FINRA AI Report, supra note 9, at 5 (``The use of AI-based 
applications is proliferating in the securities industry and 
transforming various functions within broker-dealers.'').
---------------------------------------------------------------------------

    In light of these concerns, and the harm to investors that can 
result when firms act on conflicts of interest, we are proposing rules 
to address conflicts of interest associated with a firm's use of PDA-
like technologies when interacting with investors that are contrary to 
the public interest and the protection of investors. In particular, the 
recent and rapid expansion of PDA-like technologies in the context of 
investment-related activities, without specific oversight obligations 
tailored to the specific risks involved in their use, can lead to 
outcomes that financially benefit firms at the expense of investors. 
Such a harm to investors might include the use of PDA-like technologies 
that prompt investors to enroll in products or services that 
financially benefit the firm but may not be consistent with their 
investment goals or risk tolerance, encourage investors to enter into 
more frequent trades or employ riskier trading strategies (e.g., margin 
trading) that will increase the firm's profit at the investors' 
expense, or inappropriately steer investors toward complex and risky 
securities products inconsistent with investors' investment objectives 
or risk profiles that result in harm to investors but that financially 
benefit the firm. Due to the inherent complexity and opacity of these 
technologies as well as their potential for scaling, we are proposing 
that such conflicts of interest should be eliminated or their effects 
should be neutralized, rather than handled by other methods of 
addressing the conflicts, such as through disclosure and consent. 
Moreover, many of these technologies provide means--for example, A/B 
testing \74\--to empirically assess the conflicts' impact and thus to 
neutralize the effect of a conflict on investors. Further, reliance on 
scalable, complex, and opaque PDA-like technologies can result in 
operational challenges or shortcomings. For example, failure to 
identify and address conflicts that may be present in the PDA-like 
technology used to steer investors toward a product or service could 
result in a firm's failure to identify the risks to investors of 
certain investing behaviors that place the firm's interest ahead of 
investors' interest as well as inadequate compliance policies and 
procedures that would assist the firm in curbing these practices. As a 
consequence, this could result in the failure to take sufficient steps 
to address the potentially harmful effect of those conflicts.\75\ For 
these additional reasons, we are proposing that such conflicts of 
interest be eliminated or their effects be neutralized, rather than 
handled by other methods of addressing the conflicts, such as through 
disclosure and consent.
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    \74\ A/B testing refers to running a learning model on two 
different datasets with a single change between the two, which can 
help identify causal relationships and, through understanding how 
changes affect outcomes, gain a better understanding of the 
functionality of a model. See Seldon, A/B Testing for Machine 
Learning (July 7, 2021) (``Seldon''), https://www.seldon.io/a-b-testing-for-machine-learning.
    \75\ See, e.g., William Shaw and Aisha S. Gani, Wall Street 
Banks Seizing AI to Rewire the World of Finance, Financial Review 
(June 1, 2023) (in discussing fiduciary duty obligation when using 
AI in finance quoting a law firm partner as saying: ``How do you 
demonstrate to investors and regulators that you've done your duty 
when you've used an output without really knowing what the inputs 
are?'').
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4. Use of Predictive Data Technologies in Investor Interactions
    Firms may use PDA-like technologies to transform user interfaces 
and the interactions that investors have on digital platforms.\76\ For 
example, firms may collect data from a variety of internal sources 
(e.g., trading desks, customer account histories, and communications) 
and external sources (e.g., public filings, social media platforms, and 
satellite images) in both structured and unstructured formats,\77\ 
enabling them to develop an understanding of investor preferences and 
adapt the interface and related prompts to appeal to those preferences. 
Firms may use these tools to increase the quantity of information used 
to support investment ideas,\78\ leverage investor data to send 
targeted questionnaires to investors regarding evolving investment 
goals, identify which investors might be open to a new investment 
product, or identify which investors are most likely to stop using a 
firm's services.\79\ We are concerned, however, that a firm's use of 
PDA-like technologies when engaging or communicating with--including by 
providing information to, providing recommendations or advice to, or 
soliciting--a prospective or current investor could take into 
consideration the firm's interest in a manner that places its interests 
ahead of investors' interests and thus harm investors.\80\ For example, 
some members of the public have expressed concern that firms' use of 
these PDA-like technologies encourages practices that are profitable 
for the firm but may increase investors' costs, undermine investors' 
performance, or expose investors to

[[Page 53968]]

unnecessary risks based on their individual investment profile, such 
as: (i) excessive trading,\81\ (ii) using trading strategies that carry 
additional risk (e.g., options trading and trading on margin), and 
(iii) trading in complex securities products that are more remunerative 
to the firm but pose undue risk to the investor.\82\
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    \76\ See, e.g., FSB AI Report, supra note 9, at 14-15 (chatbots 
are being introduced by a range of financial services firms, often 
in mobile apps or social media, and chatbots are ``increasingly 
moving toward giving advice and prompting customers to act'').
    \77\ See FINRA AI Report, supra note 9, at 4.
    \78\ See Deloitte, Artificial intelligence: The next frontier 
for investment management firms (Feb. 5, 2019), https://www.deloitte.com/global/en/Industries/financial-services/perspectives/ai-next-frontier-in-investment-management.html.
    \79\ See Ryan W. Neal, Three Firms Where Artificial Intelligence 
is Helping with Financial Planning (Jan. 17, 2020), https://www.investmentnews.com/artificial-intelligence-advisers-176541 
(describing current uses of AI and their potential application to 
broker-dealers and investment advisers).
    \80\ While the proposed rules apply more broadly to the use of 
covered technology in investor interactions, as discussed below, 
firms using covered technology to provide advice or make 
recommendations are subject to standards of conduct, among other 
regulatory obligations, that already apply to such advice or 
recommendations. See infra section III.C.3. The proposed conflicts 
rules would apply in addition to these standards of conduct and 
other regulatory obligations.
    \81\ See, e.g., Comment Letter from Pace Investor Rights Clinic 
(Oct. 1, 2021) (``Pace University Letter'') (``DEPs can lead 
investors to trade more frequently and more often than is in their 
best interest. For example, the push notification feature provides 
investors with live price updates. This intentionally prompts 
investors to check their portfolios after receiving the 
notification, which can lead them to make additional trades or spend 
more time on the platform than they would have otherwise. 
Traditionally, the goal of investing for most retail investors is to 
save for the long term. Frequently checking their portfolio may 
cause investors to make decisions not in line with the goal of long-
term saving and generational wealth building.''). See also, e.g., 
Feedback Flyer Response of Lincoln Li on S7-10-21 (Aug. 27, 2021) 
(``I started half a decade ago following value investing practices. 
However, [online investment and trading apps], that I used for a 
short time got me into day trading and speculation more frequently. 
I ended up stopping using these apps because they took up so much 
time with little gain. I spent more time long term trading based off 
of proper market factors and evaluation. There's a big concern to 
me, especially as a professional game designer, as to how 
gamification in life impacting subjects can have negative impact on 
society, culture and personal finances. I have friends who got into 
technical trading and day trading due to these apps, who talk more 
like gamblers than actual investors. It sets a very poor precedent 
for this industry and behavior.''); Feedback Flyer Response of 
Richard Green on S7-10-21 (Sept. 25, 2021) (responding to a question 
about online trading and investment platforms: ``[m]y broker rewards 
referrals by offering free stocks for each referral. I think this 
pulls new investors into trading, which makes a lot of money for the 
broker, as newer investors are more likely to trade too frequently 
or make mistakes.''); Feedback Flyer Response of Joseph on S7-10-21 
(Aug. 28, 2021) (``[A trading app's] user interface is set up in a 
way to subconsciously influence retail traders to trade more 
frequently and engage in riskier investment products (options) than 
the average amount.'').
    \82\ In Congressional hearings related to market events in 
January 2021, investor protection concerns were identified relating 
to the use of certain types of DEPs, including advertisements 
targeted towards specific groups of investors on digital platforms 
and game-like features on mobile apps. See Game Stopped? Who Wins 
and Loses When Short Sellers, Social Media, and Retail Investors 
Collide: Hearing Before the H. Comm. on Fin. Servs., 113th Cong. 
(2021), https://financialservices.house.gov/calendar/eventsingle.aspx?EventID=407107; Game Stopped? Who Wins and Loses 
When Short Sellers, Social Media, and Retail Investors Collide, Part 
II: Hearing Before the H. Comm. on Fin. Servs., 113th Cong. (2021), 
https://financialservices.house.gov/calendar/eventsingle.aspx?EventID=406268, Game Stopped? Who Wins and Loses 
When Short Sellers, Social Media, and Retail Investors Collide, Part 
III: Hearing Before the H. Comm. on Fin. Servs., 113th Cong. (2021), 
https://financialservices.house.gov/calendar/eventsingle.aspx?EventID=407748; Who Wins on Wall Street? GameStop, 
Robinhood, and the State of Retail Investing: Hearing Before the S. 
Comm. On Banking, Hous., & Urban Affairs, 113th Cong. (2021), 
https://www.banking.senate.gov/hearings/who-wins-on-wall-street-gamestop-robinhoodand-the-state-of-retail-investing.
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    In some cases, the use of PDA-like technologies to place a firm's 
interests ahead of investors' interests could reflect an intentional 
design choice.\83\ In other cases, however, the actions that place a 
firm's interests ahead of the interest of investors may instead reflect 
the firm's failure to fully understand the effects of its use of PDA-
like technologies or to provide appropriate oversight of its use of 
such technologies.\84\ For example, AI and other similar technology are 
only as good as the data upon which it is based. Corrupted or 
mislabeled data, biased data, or data from unknown sources, can 
undermine data quality, leading to skewed outcomes with opaque biases 
as well as unintended failures.\85\
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    \83\ See, e.g., Megan Ji, Note, Are Robots Good Fiduciaries? 
Regulating Robo-Advisors Under the Investment Advisers Act of 1940, 
117 Colum. L. Rev. 1543, 1580 (Oct. 2017) (recommending that the 
Commission adopt regulations in which ``robo-advisors, in their 
disclosures, clearly delineate between conflicts that are programmed 
into their algorithms and conflicts that may affect the design of 
algorithms.'').
    \84\ See Catherine Thorbecke, Plagued with errors: A news 
outlet's decision to write stories with AI backfires, CNN (Jan. 23, 
2023), https://www.cnn.com/2023/01/25/tech/cnet-ai-tool-news-stories/.
    \85\ See, e.g., Regulation Systems Compliance and Integrity, 
Release No. 34-97143 (Mar. 15, 2023) [88 FR 23146 (Apr. 14, 2023)] 
(describing the potential market impact of a corrupted data 
security-based swap data repository). See also National Institute of 
Science and Technology Special Publication 1270, Towards a Standard 
for Identifying and Managing Bias in Artificial Intelligence (Mar. 
2022), at section 3.1 (describing dataset challenges resulting in AI 
bias, discrimination, and systematic gaps in performance); Thor 
Olavsrud, 7 famous analytics and AI disasters (Apr. 15, 2022), 
https://www.cio.com/article/190888/5-famous-analytics-and-ai-disasters.html.
---------------------------------------------------------------------------

    While the risk of poor data quality or skewed data is not unique to 
AI, the ability of PDA-like technologies used in investor interactions 
to process data more quickly than humans, and the potential for 
technology to disseminate the resulting communications to a mass 
market, can quickly magnify conflicts of interest and any resulting 
negative effects on investors. Moreover, erroneous data considered by a 
firm's algorithm could have the effect of optimizing for the firm's 
interest over investors' interest by, for example, relying on outdated, 
previously higher cost information of investment options sponsored by 
other firms but relying on updated, lower cost information of identical 
investment options sponsored by the firm. This could result in a 
recommendation, advice, or other investor interaction that favors the 
firm's sponsored products and creates a conflict, regardless of whether 
the firm intentionally developed the algorithm to optimize for its 
interest.\86\ Poor data quality or skewed data could not only limit the 
learning capability of an AI or machine learning system but could also 
potentially negatively impact how it makes inferences and decisions in 
the future,\87\ giving rise to erroneous or poor predictions, resulting 
in a failure to achieve the system's intended objectives,\88\ and 
benefiting the firm over investors (whether intentionally or 
unintentionally).
---------------------------------------------------------------------------

    \86\ In this example, it is also possible that erroneous data 
could result in the reverse effect, generating a recommendation in 
favor of a non-sponsored product when the firm's sponsored product 
may be more cost-effective. This would not result in a conflict 
under the proposed rules but would nonetheless be subject to firms' 
obligations under their respective regulatory regimes, including the 
applicable standard of conduct.
    \87\ See Artificial Intelligence/Machine Learning Risk & 
Security Working Group (AIRS), Artificial Intelligence Risk & 
Governance, at 2.1.1 (accessed Apr. 18, 2023) (``AIRS White 
Paper''), https://aiab.wharton.upenn.edu/research/artificial-intelligence-risk-governance/.
    \88\ Id.
---------------------------------------------------------------------------

    We have observed instances where conflicts of interest associated 
with a firm's use of PDA-like technologies have resulted in harm to 
investors. A recent enforcement action involved allegations that an 
adviser marketed that its ``no fee'' robo-adviser portfolios were 
determined through a ``disciplined portfolio construction methodology'' 
when they allegedly were pre-set to hold a certain percent of assets in 
cash because the adviser's affiliate was guaranteed a certain amount of 
revenue at these levels. The adviser allegedly did not disclose its 
conflict of interest in setting the cash allocations; that this 
conflict resulted in higher cash allocations, which could negatively 
impact performance in a rising market; and that the cash allocations 
were higher than other services because clients did not pay a fee.\89\ 
While the focus of that action was on the alleged disclosure failure, 
it also highlights the potential for PDA-like technologies to be used 
in ways that advance a firm's interests at the expense of its 
investors' interests. The proposed conflicts rules would require a firm 
to analyze its investor interactions that use PDA-like technology for 
the types of conflicts of interest that were at issue in that action in 
order to determine whether the investor interaction places the firm's 
interests ahead of its investors' interests and, if so, eliminate, or 
neutralize the effect of, the conflicts of interest on investors. In 
addition, the Commission's 2021 Request for Information and Comments on 
Broker-Dealer and

[[Page 53969]]

Investment Adviser Digital Engagement Practices, Related Tools and 
Methods, and Regulatory Considerations and Potential Approaches 
(``Request'') \90\ solicited comments related to conflicts of interest, 
among other areas.\91\ In response, the Commission received comments 
reflecting perceived conflicts of interest related to the use of online 
investing and trading applications, which some commenters indicated 
undermine their faith in the fairness of the markets.\92\
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    \89\ In re. Charles Schwab & Co., Inc., et al., Exchange Act 
Release No. 95087 (June 13, 2022) (settled order).
    \90\ See Request for Information and Comments on Broker-Dealer 
and Investment Adviser Digital Engagement Practices, Related Tools 
and Methods, and Regulatory Considerations and Potential Approaches, 
Exchange Act Release No. 92766 (Aug. 27, 2021) [86 FR 49067 (Sept. 
1, 2021)].
    \91\ See id., questions 1.26, 2.6, 3.5, 3.16, and 4.15. For 
additional discussion regarding the Request, see infra section I.B.5
    \92\ See, e.g., Feedback Flyer Response of Tomas Liutvinas on 
S7-10-21 (Aug. 28, 2021) (``It seems like there is no conflict of 
interest regulations in the US financial system. This makes me 
uneasy. Until the rights are fully explained, reported, and undone I 
will recommend to anyone I know to stay away from US markets. For 
myself, I've invested in a certain position with plans to leave the 
investment for the future generations of my family, to hold on 
hopefully up to a point when markets will be made transparent and 
fair.''); Feedback Flyer Response of Jasper Pummell on S7-10-21 
(Aug. 28, 2021) (``I believe that online brokerages have a conflict 
of interest and financial regulation is needed to ensure that the 
markets are a safe place for retail traders.''); Feedback Flyer 
Response of Robert on S7-10-21 (Aug. 27, 2021) (``Retail needs a 
fair and transparent market. There are blantant [sic] conflicts of 
interest in the market which should be rectified immediately. 
Failure to do so will have a mass exodus of investors from the US 
stock market.''). See also FINRA AI Report, supra note 9, at 11 
(``However, use of AI also raises several concerns that may be wide-
ranging across various industries as well as some specific to the 
securities industry. Over the past few years, there have been 
numerous incidents reported about AI applications that may have been 
fraudulent, nefarious, discriminatory, or unfair, highlighting the 
issue of ethics in AI applications.''). But see, e.g., Comment 
Letter from David Dusseault, President, Robinhood Financial, LLC 
(Oct. 1, 2021) (``Robinhood Letter'') (stating that conflicts of 
interest are not new to the financial industry and that the 
regulatory frameworks established by the SEC, such as Reg BI and the 
disclosure requirements of the Investment Advisers Act of 1940, rest 
on the principle that conflicts of interest exist, but investors are 
able to navigate them when they are adequately disclosed); Comment 
Letter from Investment Adviser Association (Oct. 1, 2021) (``IAA 
Letter''); Comment Letter from Kevin M. Carroll, Managing Director 
and Associate General Counsel, Securities Industry and Financial 
Markets Association (Oct. 1, 2021) (``SIFMA Letter'') (generally 
opposing new rules, guidance, or interpretations to address the use 
of digital engagement practices). These comments are all available 
in the comment file at https://www.sec.gov/comments/s7-10-21/s71021.htm.
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    Failures to appropriately oversee these PDA-like technologies 
compound the risk that conflicts of interest may not be appropriately 
identified or managed. Due to the complexity and opacity of certain 
technologies, firms should have robust practices to appropriately 
oversee and understand their use and take steps to identify and 
appropriately address any associated conflicts of interest. For 
example, without appropriate personnel, a firm may not have the ability 
to modify the software or may lack the expertise to understand, 
monitor, or appropriately update code, limiting the firm's ability to 
identify and appropriately address associated conflicts of interest. 
Furthermore, if the firm does not understand how the technology 
operates--including whether it takes into consideration the firm's 
interest and how it can influence investor conduct--the firm may not 
fully understand whether, how, or the extent to which it is placing the 
firm's interests ahead of investors' interests. As a result of the 
complexity and opacity of PDA-like technologies, a firm needs different 
and specific practices to evaluate its use of the technology and 
recognize the risk of conflicts presented by that use compared to other 
practices. Without appropriate oversight and understanding of the 
conflicts of interest that could be amplified when the technology is 
incorporated into investor-facing interactions, such as design 
elements, features, or communications that nudge or prompt certain or 
more immediate action by an investor, investor harm can result.
5. Request for Information and Comment
    In August 2021, the Commission issued a request for information and 
public comment on the use of DEPs by broker-dealers and investment 
advisers, as well as the analytical and technological tools and methods 
used in connection with these DEPs.\93\ For purposes of the Request, 
the Commission defined DEPs broadly to include behavioral prompts, 
differential marketing, game-like features, and other design elements 
or features designed to engage retail investors.\94\ The Commission 
stated that DEPs may be designed to encourage account opening, account 
funding and trading, or may be designed solely to increase investor 
engagement with investing apps, as there may be value in the number of 
investors interacting with the platform, how often they visit, and how 
long they stay.\95\ The Request was issued in part to assist the 
Commission and its staff in better understanding the market practices 
associated with the use of DEPs by firms, facilitate an assessment of 
existing regulations and consideration of whether regulatory action may 
be needed to further the Commission's mission in connection with firms' 
use of DEPs, as well as to provide a forum for market participants 
(including investors), and other interested parties to share their 
perspectives on the use of DEPs and the related tools and methods, 
including potential benefits that DEPs provide to retail investors, as 
well as potential investor protection concerns.\96\
---------------------------------------------------------------------------

    \93\ See Request, supra note 90.
    \94\ See id. at 49067.
    \95\ See id. at 49069.
    \96\ As noted in the Request, the market practices explored 
included: (i) the extent to which firms use DEPs; (ii) the types of 
DEPs most frequently used; (iii) the tools and methods used to 
develop and implement DEPs; and (iv) information pertaining to 
retail investor engagement with DEPs, including any data related to 
investor demographics, trading behaviors, and investment 
performance. See id. at 49068.
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    The Commission received over 2,300 public comments, including 
submissions provided through an online ``feedback flyer'' that 
accompanied the Request and was provided to better facilitate responses 
from retail investors.\97\ Commenters offered a wide range of 
perspectives on broker-dealers' and investment advisers' use of DEPs, 
addressing their purpose, providing information on how investors 
interact with them, and offering broad reflections on potential 
regulatory action. Commenters also provided views on benefits and risks 
related to firms' use of DEPs, as well as the AI/machine learning and 
behavioral psychology that firms use to develop and deploy DEPs.\98\
---------------------------------------------------------------------------

    \97\ The ``Feedback Flyer'' was attached as Appendix A to the 
Request and asked individual investors to provide their comments 
with regard to online trading or investment platforms, such as 
websites and mobile applications, to provide the Commission with a 
better understanding of retail investors' experiences on these 
platforms. The Feedback Flyer provided 11 different question 
prompts, with an array of both multiple choice, and free text 
response options whereby respondents could submit relevant comments. 
Comments received in response to the Request are available at 
https://www.sec.gov/comments/s7-10-21/s71021.htm.
    \98\ See, e.g., Comment Letter from American Securities 
Association (Sept. 30, 2021); Comment Letter from Securities 
Arbitration Clinic and Professor of Clinical Legal Education, St. 
John's University School of Law Securities Arbitration Clinic, (Oct. 
1, 2021) (``St. John's Letter''); Comment Letter from Morningstar, 
Inc. and Morningstar Investment Management, LLC (Oct. 1, 2021) 
(``Morningstar Letter''); Comment Letter from James F. Tierney, 
Assistant Professor of Law, University of Nebraska College of Law 
(Oct. 1, 2021) (``Tierney Letter''); Pace University Letter; Comment 
Letter from Law Office of Simon Kogan, (Oct. 17, 2021) (``Kogan 
Letter'').
---------------------------------------------------------------------------

    A number of commenters also provided detailed feedback regarding 
the potential need for additional action to address the issues 
presented by DEPs and their underlying technology. For example, 
multiple commenters raised concerns over the risks of harm to investors 
if the Commission did not act, and requested that the Commission 
interpret existing regulations in a way

[[Page 53970]]

that would apply to most DEPs and/or adopt additional regulations to 
address those risks.\99\ Many of these commenters suggested a need to 
address the standards of conduct applicable to broker-dealers and 
investment advisers when interacting with retail investors through 
digital platforms.\100\ Some of these commenters noted that Reg BI does 
not apply to firms with a self-directed brokerage business model, 
including those that use DEPs \101\ and provided additional suggestions 
that the Commission could take to address firms' use of DEPs.\102\ 
Others provided detailed opinions as to the application of an 
investment adviser's fiduciary duty to DEPs.\103\ A significant number 
of commenters also addressed other laws and regulations and their 
sufficiency, or lack thereof, in their application to DEPs, including 
discussion addressing (i) antifraud and general standards of conduct; 
\104\ (ii) regulation of advertising, marketing, and communications 
with the public; \105\ (iii) compliance and supervision obligations; 
\106\ (iv) data privacy and cybersecurity concerns; \107\ (v) customer 
onboarding obligations; \108\ (vi) Commission Staff's 2017 Robo-Adviser 
Guidance; \109\ and (vii) the Advisers Act recordkeeping rule.\110\
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    \99\ See, e.g., Comment Letter from Scopus Financial Group 
(Sept. 20, 2021); Comment Letter from Better Markets, Inc. (Oct. 1, 
2021) (``Better Markets Letter''); Comment Letter from Public 
Investors Advocate Bar Association (Oct. 1, 2021) (``PIABA 
Letter''); Comment Letter from University of Miami School of Law 
Investor Rights Clinic et al. (Oct 1, 2021) (``University of Miami 
Letter''); Comment Letter from Fidelity Investments (Oct. 1, 2021); 
St. John's Letter; Morningstar Letter. We also considered views 
received from the SEC's Investor Advisory Committee on ethical 
guidelines for artificial intelligence and algorithmic models used 
by investment advisers. See Investor Advisory Committee, 
Establishment of an Ethical Artificial Intelligence Framework for 
Investment Advisors (Apr. 6, 2023), https://www.sec.gov/files/20230406-iac-letter-ethical-ai.pdf.
    \100\ See, e.g., Pace University Letter (``We believe that 
retail investors, particularly novice investors, believe that they 
are receiving advice or recommendations from DEPs. This includes the 
top mover list, analyst ratings, push notifications, and other DEPs 
that encourage investment activity. Many of our survey participants 
stated that they believe that these DEPs influenced their decision-
making. At the same time, DEPs may also influence investor decision-
making without investors being conscious of it.''); Comment Letter 
from North American Securities Administrators Association (Oct. 1, 
2021) (``NASAA Letter'') (``To assist with compliance and to protect 
investors, the Commission should provide further guidance as to when 
DEP-based communications constitute recommendations. However, given 
the speed of technology, NASAA suggests that guidance should not be 
limited to any particular DEP, but rather should be focused on the 
effects of technologies on investor behavior generally.''); Comment 
Letter from Fiduciary Insights and Practice Growth Partners (Sept. 
30, 2021) (``Aikin/Mindicino Letter'') (``[A]s the complexity and 
heterogeneity of wants, needs, and capabilities of the clientele 
rises, the sophistication and artificial intelligence and machine 
learning (AI/ML) of the DEPs must increase dramatically. 
Commensurately, the internal oversight and regulatory guardrails to 
assure that customer/client best interests are served must also 
increase.''); see also Comment Letter from Morgan Stanley Wealth 
Management (Oct. 1, 2021) (``Morgan Stanley Letter'') (while noting 
existing protections, stating that ``[s]hould the Commission believe 
additional guidance is necessary, we suggest the adoption of 
principles-based, technology neutral adjustments to the existing 
regulatory regime to address the fast evolving technological 
landscape''); Better Markets Letter; University of Miami Letter 
(``As the SEC continues its review of standards applicable to 
financial professional[s], it is critical to enhance investor 
protection in the fast-growing and increasingly harmful digital 
platform environment.'').
    \101\ See, e.g., Robinhood Letter (``The SEC acknowledged the 
benefits of a self-directed model such as Robinhood's in adopting 
Reg BI, explicitly stating that Reg BI does not apply to this 
model.'').
    \102\ See, e.g., Pace University Letter (``DEPs and online 
platforms have expanded access to the market to new investors, while 
at the same time influencing the decision-making of those 
investors--particularly novice investors--in ways that are often in 
conflict with their bests interest.''); see also Tierney Letter; 
Better Markets Letter; SIFMA Letter; Morningstar Letter; Morgan 
Stanley Letter; University of Miami Letter (``Due to the influential 
nature of DEPs, the SEC should enhance the Regulation Best Interest 
disclosure obligation and conflict of interest obligation by 
requiring firms to flag investor trades and/or positions where there 
is a likelihood that the firm will act in a manner adverse to the 
investor's position and to notify investors of these potential 
actions.'').
    \103\ See, e.g., IAA Letter (``Some advisers also use various 
analytical and technological tools to develop and provide investment 
advice, including through online platforms or as part of enhancing 
their in-person investment advisory services. Investment advisers 
may also engage in DEPs to develop and provide investor education 
and related tools.''); see also Comment Letter from Envestnet Asset 
Management, Inc. (Oct. 1, 2021) (``Envestnet Letter''); Comment 
Letter from Julius Leiman-Carbia, Chief Legal Officer, Wealthfront 
Corporation (Oct. 8, 2021) (``Wealthfront Letter''); NASAA Letter; 
Aikin/Mindicino Letter; Better Markets Letter; SIFMA Letter; 
University of Miami Letter; Morgan Stanley Letter.
    \104\ See, e.g., Comment Letter from Jennifer Schulp, Director 
of Financial Regulation Studies, Center for Monetary and Financial 
Alternatives, CATO Institute (Oct. 1, 2021) (``CATO Institute 
Letter''); Comment Letter from Brandon Krieg, CEO, Stash Financial, 
Inc. and Stash Investments LLC (Oct. 1, 2021) (``Stash Letter''); 
Wealthfront Letter; IAA Letter; Robinhood Letter; SIFMA Letter; 
Tierney Letter.
    \105\ See, e.g., PIABA Letter; CATO Institute Letter; IAA 
Letter.
    \106\ See, e.g., Comment Letter from James J. Angel, Ph.D., CFP, 
CFA, Associate Professor of Finance, McDonough School of Business, 
Georgetown University (Sept. 30, 2021); IAA Letter; Stash Letter; 
Aikin/Mindicino Letter; PIABA Letter; CATO Institute Letter.
    \107\ See, e.g., NASAA Letter; Envestnet Letter; Kogan Letter.
    \108\ See, e.g., University of Miami Letter.
    \109\ See, e.g., Comment Letter from Penny Lee, CEO, Financial 
Technology Association (Oct. 1, 2021); IAA Letter.
    \110\ See, e.g., Comment Letter from Pamela Lewis Marlborough, 
Managing Director and Associate General Counsel, Teachers Insurance 
and Annuity Association of America (Oct. 1, 2021); SIFMA Letter; 
University of Miami Letter.
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C. Overview of the Proposal

    In view of Commission staff observations, our experience 
administering our existing rules, the discussion in section 1.B. above 
on the development of PDA-like technologies in firm investor 
interactions and the unique risks they raise regarding conflicts of 
interest, and comments received in response to the Request, we are 
proposing to update the regulatory framework to help ensure that firms 
are appropriately addressing conflicts of interest associated with the 
use of PDA-like technologies. Specifically, we propose that firms 
should be required to identify and eliminate, or neutralize the effect 
of, certain conflicts of interest associated with their use of PDA-like 
technologies because the effects of these conflicts of interest are 
contrary to the public interest and the protection of investors.\111\
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    \111\ See infra section II.A.2.e.
---------------------------------------------------------------------------

    Proposed rules 15l-2 under the Exchange Act (17 CFR 240.15l-2) and 
211(h)(2)-4 under the Advisers Act (17 CFR 275.211(h)(2)-4) 
(collectively, the ``proposed conflicts rules'') are designed to 
address the conflicts of interest associated with firms' use of PDA-
like technology when engaging in certain investor interactions, and the 
proposed rules would do so in a way that aligns with (and in some 
respects may satisfy) firms' existing regulatory obligations.\112\ 
Except as specifically noted, the texts of proposed conflicts rule 
applicable to brokers and dealers (17 CFR 240.15l-2) and the proposed 
conflicts rule applicable to investment advisers (17 CFR 275.211(h)(2)-
4) would be substantially identical.\113\ The proposed conflicts rules 
would only apply where the firm uses defined covered technology--more 
specifically, an analytical, technological, or computational function, 
algorithm, model, correlation matrix, or similar method or process that 
optimizes for, predicts, guides, forecasts, or directs investment-
related behaviors or outcomes in an investor interaction.
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    \112\ See id.
    \113\ Citations herein to the ``proposed conflicts rules'' 
reference each of the proposed conflicts rules as they would be 
codified in each location. Citations to a particular section of the 
CFR reference only the proposed conflicts rule that would apply to 
broker-dealers or to investment advisers, as applicable.
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    The proposal is designed to be sufficiently broad and principles-
based to continue to be applicable as technology develops and to 
provide firms with flexibility to develop approaches to their use of 
technology consistent with their business model, subject to the over-
arching requirement

[[Page 53971]]

that they need to be sufficient to prevent the firm from placing its 
interests ahead of investor interests. The proposal is also designed to 
be consistent with the Commission's prior actions regarding 
technological innovation.\114\ We note that the staff has also provided 
their views on the industry's expanding use of technology in the 
context of robo-advisers \115\ and shared examination findings and 
risks associated with the use of robo-advisory products,\116\ among 
other areas.
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    \114\ Historically, the Commission has reviewed the changing 
technology landscape, provided guidance, and if necessary amended 
its regulatory framework to protect investors while still allowing 
firms' use of technology to innovate and benefit investors. See, 
e.g., Use of Electronic Media for Delivery Purposes, Release No. 
7233 (Oct. 6, 1995) [60 FR 53458 (Oct. 10, 1995] (providing 
Commission views with respect to the use of electronic media for 
information delivery under the Securities Act of 1933, the 
Securities Exchange Act of 1934, and the Investment Company Act of 
1940); Use of Electronic Media by Broker-Dealers, Transfer Agents, 
and Investment Advisers for Delivery of Information, Exchange Act 
Release No. 37182 (May 9, 1996) [61 FR 24644 (May 15, 1996)] (``1996 
Release'') (providing Commission views on electronic delivery of 
required information by broker-dealers, transfer agents and 
investment advisers); and Use of Electronic Media, Exchange Act 
Release No. 42728 (Apr. 28, 2000) [65 FR 25843 (May 4, 2000)] 
(``2000 Release'') (providing interpretive guidance on the use of 
electronic media to deliver documents on matters such as telephonic 
and global consent; issuer liability for website content; and legal 
principles that should be considered in conducting online 
offerings). In addition, the Commission has amended regulations to 
accommodate evolving technologies and changes in the way investors 
consume information. See, e.g., Tailored Shareholder Reports for 
Mutual Funds and Exchange-Traded Funds; Fee Information in 
Investment Company Advertisements, Investment Company Act Release 
No. 34731 (Oct. 26, 2022) (87 FR 72758 [Nov. 25, 2022]) (requiring 
layered disclosure for funds' shareholder reports and graphical 
representations of fund holdings); Investment Adviser Marketing, 
Investment Advisers Act Release No. 5653 (Dec. 22, 2020) [86 FR 
13024 (Mar. 5, 2021)] (adopting ``principles-based provisions 
designed to accommodate the continual evolution and interplay of 
technology and advice,'' and providing specific guidance regarding, 
among others, the use of social media). Further, the Commission has 
amended regulations to expand the use of electronic filing options 
by investment advisers and institutional investment managers and 
updated recordkeeping requirements to make them adaptable to new 
technologies in electronic recordkeeping. See, e.g., Electronic 
Submission of Applications for Orders under the Advisers Act and the 
Investment Company Act, Confidential Treatment Requests for Filings 
on Form 13F, and Form ADV-NR; Amendments to Form 13F, Advisers Act 
Release No. 6056 (June 23, 2022) [87 FR 38943 (June 30, 2022)]; see 
also Electronic Recordkeeping Requirements for Broker-Dealers, 
Security-Based Swap Dealers, and Major Security-Based Swap 
Participants, Exchange Act Release No. 96034 (Oct. 12, 2022) [87 FR 
66412 (Nov. 3, 2022)] (``Electronic Recordkeeping Release'').
    \115\ See Robo-Advisers, Division of Investment Management 
Guidance Update No. 2017-02 (Feb. 2017) (``2017 IM Guidance''), 
https://www.sec.gov/investment/im-guidance-2017-02.pdf (addressing 
among other things, presentation of disclosures, provision of 
suitable advice, and effective compliance programs).
    \116\ See Observations from Examinations of Advisers that 
Provide Electronic Investment Advice, Division of Examinations Risk 
Alert (Nov. 9, 2021) (``2021 Risk Alert''), https://www.sec.gov/files/exams-eia-risk-alert.pdf (noting, ``[n]early all of the 
examined advisers received a deficiency letter, with observations 
most often noted in the areas of: (1) compliance programs, including 
policies, procedures, and testing.'').
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    The proposal draws upon our authority under section 211(h) of the 
Advisers Act and section 15(l) of the Exchange Act. The Dodd-Frank Wall 
Street Reform and Consumer Protection Act of 2010 (``Dodd-Frank Act'') 
added section 211(h)(2) to the Advisers Act and section 15(l)(2) to the 
Exchange Act, each of which, among other things, authorizes the 
Commission to ``promulgate rules prohibiting or restricting certain 
sales practices, conflicts of interest, and compensation schemes for 
brokers, dealers, and investment advisers that the Commission deems 
contrary to the public interest and the protection of investors.'' 
\117\
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    \117\ See Section 913 of the Dodd-Frank Wall Street Reform and 
Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010). As 
noted in note 8 to subsection (l), another subsection (l) is set out 
after the first subsection (k) of the Exchange Act.
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    The proposal is intended to be technology neutral. We are not 
seeking to identify which technologies a firm should or should not use. 
Rather, the proposal builds off existing legal standards and, as 
discussed throughout the release, is designed to address certain risks 
to investors associated with firms' use of certain technology in their 
interactions with investors, regardless of which such technology is 
used.\118\ The proposal also is designed to permit firms the ability to 
employ tools that they believe would address these risks that are 
specific to the particular technology they use consistent with the 
proposal. The Commission has long acted to protect investors from the 
harms arising from conflicts of interests and will continually assess 
the harms and revise those protections in light of the evolution of 
practices, including with regard to firms' use of technologies. As 
discussed in further detail below, conflicts associated with the use of 
PDA-like technologies should be eliminated or their effects neutralized 
to protect investors from conflicts of interest associated with firms' 
use of PDA-like technologies that results in investor interactions that 
place the interests of the firm and its associated persons ahead of 
investors' interests.
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    \118\ Firms' use of PDA-like technology may also be subject to 
other potential legal and contractual restrictions on the ability 
for advisers and brokers to collect and use customer information. 
See, e.g., 17 CFR part 248, subpart A (Regulation S-P), requiring, 
among other things, brokers, dealers, investment companies, and 
registered investment advisers to adopt written policies and 
procedures for administrative, technical, and physical safeguards to 
protect customer records and information.
---------------------------------------------------------------------------

    In particular, the proposed conflicts rules would generally require 
the following:
     Elimination, or neutralization of effect of, conflicts of 
interest. The proposed conflicts rules would require a firm to (i) 
evaluate any use or reasonably foreseeable potential use by the firm or 
its associated person \119\ of a covered technology in any investor 
interaction to identify any conflict of interest associated with that 
use or potential use; \120\ (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 neutralize the effect of, those conflicts of interest 
that place the firm's or its associated person's interest ahead of the 
interest of investors.
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    \119\ As used in this release, the term ``associated person'' 
means, for investment advisers, a natural person who is a ``person 
associated with an investment adviser'' as defined in section 
202(a)(17) of the Advisers Act and, for broker-dealers, a natural 
person who is an ``associated person of a broker or dealer'' as 
defined in section 3(a)(18) of the Exchange Act.
    \120\ Covered technology, conflict of interest, investor 
interaction are each defined terms under the proposed rules. See 
proposed rules 211(h)(2)-4(a) and 15l-2(a); see also infra sections 
II.A.1 and II.A.2.c.
---------------------------------------------------------------------------

     Policies and procedures. The proposed conflicts rules 
would require a firm that has any investor interaction using covered 
technology to adopt, implement, and, in the case of broker-dealers, 
maintain, written policies and procedures reasonably designed to 
achieve compliance with the proposed conflicts rules, including (i) a 
written description of the process for evaluating any use (or 
reasonably foreseeable potential use) of a covered technology in any 
investor interaction; (ii) a written description of any material 
features of any covered technology used in any investor interaction and 
of any conflicts of interest associated with that use; (iii) a written 
description of the process for determining whether any conflict of 
interest identified pursuant to the proposed conflicts rules results in 
an investor interaction that places the interest of the firm or person 
associated with the firm ahead of the interests of the investor; (iv) 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 conflicts rules to result in an investor interaction 
that

[[Page 53972]]

places the interest of the firm or associated person ahead of the 
interests of the investor; and (v) a review and written documentation 
of that review, no less frequently than annually, of the adequacy of 
the policies and procedures established pursuant to the proposed 
conflicts rules and the effectiveness of their implementation as well 
as a review of the written descriptions established pursuant to the 
proposed conflicts rules.
    Proposed amendments to applicable recordkeeping rules, rules 17a-3 
and 17a-4 under the Exchange Act and rule 204-2 under the Advisers Act, 
would require firms to make and keep books and records related to the 
requirements of the proposed conflicts rules. These proposed amendments 
are designed to help facilitate the Commission's examination and 
enforcement capabilities, including assessing compliance with the 
requirements of the proposed conflicts rules.
    The proposal is designed to prevent firms' conflicts of interest 
from harming investors while allowing continued technological 
innovation in the industry.

II. Discussion

A. Proposed Conflicts Rules

1. Scope
    The proposed conflicts rules would apply only when a firm uses 
covered technology in an investor interaction. The proposed definitions 
are designed to identify those conflicts of interest that firms must 
evaluate to determine whether they result in investor interactions that 
place the firm's interest ahead of investors' interest and must 
therefore be eliminated or their effect neutralized.\121\ The proposed 
conflicts rules would apply to all broker-dealers and to all investment 
advisers registered, or required to be registered, with the Commission.
---------------------------------------------------------------------------

    \121\ See supra section I.B.4 (describing existing technologies 
that may involve conflicts of interest) and infra section II.A.2.c 
(discussing the proposed definition of a conflict of interest).
---------------------------------------------------------------------------

a. Covered Technology
    The proposed conflicts rules would define covered technology as an 
analytical, technological, or computational function, algorithm, model, 
correlation matrix, or similar method or process that optimizes for, 
predicts, guides, forecasts, or directs investment-related behaviors or 
outcomes.\122\ The proposed definition is designed to capture PDA-like 
technologies, such as AI, machine learning, or deep learning 
algorithms, neural networks, NLP, or large language models (including 
generative pre-trained transformers), as well as other technologies 
that make use of historical or real-time data, lookup tables, or 
correlation matrices among others.
---------------------------------------------------------------------------

    \122\ Proposed conflicts rules at (a).
---------------------------------------------------------------------------

    The rate at which these technologies evolve has increased in recent 
years and may continue to increase.\123\ Accordingly, the proposed 
definition of covered technology is also designed to capture the 
variety of technologies and methods that firms currently use as well as 
those technologies and methods that may develop over time. The proposed 
definition would include widely used and bespoke technologies, future 
and existing technologies, sophisticated and relatively simple 
technologies, and ones that are both developed or maintained at a firm 
or licensed from third parties.\124\
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    \123\ See e.g., Deloitte, Artificial intelligence: The next 
frontier for investment management firms (Feb. 5, 2019), https://www.deloitte.com/global/en/Industries/financial-services/perspectives/ai-next-frontier-in-investment-management.html 
(stating, for example, that ``[f]irms have recognized a new 
opportunity to gain direct distribution to investors, benefit from 
enhanced efficiencies in servicing small accounts, and offer value-
added services for advisors. This has translated into a wave of 
investment activity, with asset managers and intermediaries 
acquiring or investing in robo-advice technology.'') See also Bob 
Veres and Joel Bruckstein, T3/Inside Information Advisor Software 
Survey (Mar. 14, 2023), https://t3technologyhub.com/wp-content/uploads/2023/03/2023-T3-and-Inside-Information-Software-Survey.pdf.
    \124\ The SEC has proposed a new rule under the Advisers Act to 
prohibit registered investment advisers from outsourcing certain 
services or functions without first meeting minimum requirements. 
See Outsourcing by Investment Advisers, Investment Advisers Act 
Release No. 6176; File No. S7-25-22 (Oct. 26, 2022) [87 FR 68816 
(Nov. 16, 2022)] (``Proposed Outsourcing Rule''). We encourage 
commenters to review that proposal to determine whether it might 
affect comments on this proposal.
---------------------------------------------------------------------------

    The proposed definition, however, would be limited to those 
technologies that optimize for, predict, guide, forecast, or direct 
investment-related behaviors or outcomes. The use of these terms in the 
proposed conflicts rules is designed to capture a broad range of 
actions. This could include providing investment advice or 
recommendations, but it also encompasses design elements, features, or 
communications that nudge, prompt, cue, solicit, or influence 
investment-related behaviors or outcomes from investors. Investment-
related behavior or outcomes can manifest themselves in many forms in 
addition to buying, selling, and holding securities, such as an 
investor making referrals or increasing trading volume and/or 
frequency. This broad proposed definition is designed to help ensure 
that, as innovation and technology evolve and firms expand their 
reliance on technologies to provide services to, and to interact with, 
investors, our rules remain effective in protecting investors from the 
harmful impacts of conflicts of interest.
    The proposed definition would apply to the use of PDA-like 
technologies that analyze investors' behaviors (e.g., spending 
patterns, browsing history on the firm's website, updates on social 
media) to proactively provide curated research reports on particular 
investment products, because the use of such technology has been shown 
to guide or influence investment-related behaviors or outcomes. 
Similarly, using algorithmic-based tools, such as investment analysis 
tools, to provide tailored investment recommendations to investors 
would fall under the proposed definition of covered technology because 
the use of such tools is directly intended to guide investment-related 
behavior. As an additional example, a firm's use of a conditional auto-
encoder model to predict stock returns would be a covered 
technology.\125\ Similarly, if a firm utilizes a spreadsheet that 
implements financial modeling tools or calculations, such as 
correlation matrices, algorithms, or other computational functions, to 
reflect historical correlations between economic business cycles and 
the market returns of certain asset classes in order to optimize asset 
allocation recommendations to investors, the model contained in that 
spreadsheet would be a covered technology because the use of such 
financial modeling tool is directly intended to guide investment-
related behavior. Likewise, covered technology would include a 
commercial off-the-shelf NLP technology that a firm may license to 
draft or revise advertisements guiding or directing investors or 
prospective investors to use its services.
---------------------------------------------------------------------------

    \125\ An autoencoder return model is an unsupervised learning 
method that attempts to model a full panel of asset returns using 
only the returns themselves as inputs. See generally S. Gu, B. 
Kelly, and D. Xiu, Autoencoder Asset Pricing Models (Sept. 30, 
2019), https://www.aqr.com/Insights/Research/Working-Paper/Autoencoder-Asset-Pricing-Models.
---------------------------------------------------------------------------

    The proposed definition, however, would not include technologies 
that are designed purely to inform investors, such as a website that 
describes the investor's current account balance and past performance 
but does not, for example, optimize for or predict future results, or 
otherwise guide or direct any investment-related action. Similarly, the 
proposed definition also would not include a technology that predicts 
whether an investor would be approved for a particular credit card 
issued by the firm's affiliate based on other

[[Page 53973]]

information the firm knows about the investor because the use of such 
technology does not, and is not intended to, affect an investment-
related behavior or outcome. For the same reason, the use of a firm's 
chatbot that employs PDA-like technology to assist investors with basic 
customer service support (e.g., password resets or disputing fraudulent 
account activity) would not qualify as covered technology under the 
proposed definition.
    We request comment on all aspects of the definition of covered 
technology, including the following items:
    1. Is the scope of the proposed definition of a covered technology 
sufficiently clear? We intend for the proposed definition to cover PDA-
like technologies; are there ways we could revise the proposed 
definition in order to better accomplish this? Are there any 
technologies covered by the proposed definition that go beyond PDA-like 
technologies and should be excluded? For instance, should the proposed 
definition distinguish between different categories of machine learning 
algorithms, such as deep learning, supervised learning, unsupervised 
learning, and reinforcement learning processes? Do one or more of these 
categories present more investor protection concerns related to 
conflicts of interest relative to other categories? Would firms be able 
to identify what would and would not be a covered technology for 
purposes of the proposed rules? If not, what additional clarity would 
be beneficial? We have described examples of technologies to which the 
definition would or would not apply. Should the definition be revised 
to include or specifically exclude such examples?
    2. Would the definition adequately include the technology used by 
firms that would present the conflicts of interest and resulting risks 
to investors that these proposed rules are designed to address? If not, 
how should this definition be changed to further the objective of the 
proposed conflicts rules? Please explain your answer, including the 
extent to which these technologies do or do not present conflicts of 
interest risks to investors. Alternatively, do the technologies 
included in the proposed definition include technology that does not 
typically result in risks to investors that these proposed rules are 
designed to address?
    3. Is the proposed definition of covered technology appropriately 
calibrated to allow for future technological developments? What 
adjustments, if any, should the Commission make to help ensure that the 
definition of covered technology will remain evergreen despite future 
technological advancements? Conversely, what adjustments to the 
definition of covered technology, if any, are necessary to avoid 
covering those future technological advancements that do not possess 
characteristics that the proposed rules are intended to address?
    4. The proposed definition of covered technology only applies to 
technologies that are used to optimize for, predict, guide, forecast, 
or direct investment-related behaviors or outcomes. Do the terms 
``optimize for,'' ``predict,'' ``guide,'' ``forecast,'' and ``direct'' 
appropriately scope the definition? Is it clear what these terms are 
intended to capture or would further explanation be helpful? Are there 
certain technologies that would fit within one or more of those terms 
but which should be outside the scope of the proposed definition? 
Alternatively, are there certain technologies that would fall outside 
those terms but which should be within the scope of the proposed 
definition? If so, should we use additional or different words to 
clarify the meaning? For instance, should we include the term 
``influence'' in the definition? If so, how would ``influence'' differ 
from the terms ``guide'' or ``direct'' in the definition? Should we use 
``nudge'' or ``prompt'' in the definition? Alternatively, should we 
remove any of the terms in the proposed definition? For instance, are 
the terms ``guide'' and ``direct'' redundant or do they express 
distinct meanings within the context of the definition? Does ``guide'' 
capture broader activity than ``direct'' and cause the rule to capture 
technologies that should not be in scope? Should the definition be 
limited to technologies that direct or influence an investor?
    5. Should the proposed definition of covered technology apply to 
technologies that are used to optimize for, predict, guide, forecast, 
or direct investment-related behaviors or outcomes, directly or 
indirectly? Are there certain PDA-like technologies that optimize for, 
predict, guide, forecast, or direct investment-related behaviors or 
outcomes indirectly that should be covered by this definition? If so, 
what are they and why? If the definition did include the term 
``indirectly,'' would it include technologies that should not be 
covered by the proposed conflicts rules?
    6. Should the definition of covered technology not include 
technology that is solely meant to inform investors, as proposed?
    7. Does the term ``covered technology'' adequately reflect the 
definition? Should some other defined term be used, such as ``covered 
processes'' or ``covered methods''? Are there any other terms that 
should be used?
    8. Does the phrase ``investment-related behaviors or outcomes'' 
sufficiently clarify the intended scope of the rule and which 
technologies would not be within the definition? Is it clear what the 
phrase ``investment-related behaviors or outcomes'' would capture or 
would further explanation be helpful? Are there certain behaviors or 
outcomes that may not be ``investment related'' but should nonetheless 
be covered by the proposed definition? For instance, should PDA-like 
technologies used for back office or administrative functions, such as 
trade settlement, the routing of customers' orders, accounting, or 
document review and processing, be included in the covered technology 
definition? Are commenters aware of any PDA-like technology that is 
used for back office functions, such as the routing of customer orders, 
that is also used to engage or communicate with investors (i.e., that 
involve an investor interaction)? Are there certain investment-related 
activities that may not be ``behaviors or outcomes'' that should be 
covered by the definition? Is either ``behavior'' or ``outcome'' 
overbroad, capturing activities beyond those intended by the 
definition? Should a different term, such as ``investment-related 
covered technology'' be used?
    9. Are there aspects of this definition that should be broadened, 
narrowed, revised, removed, or added? For instance, should the 
definition be limited to the use of predictive data analytics and/or 
artificial intelligence that optimizes for, predicts, guides, 
forecasts, or directs investment-related behaviors or outcomes? 
Alternatively, should we limit the scope of the definition to 
technologies that are used to provide investment advice or 
recommendations? Should we otherwise limit the scope to technologies 
that are used directly by investors? Should we expressly exclude 
technologies that are not used by investors but instead are used by 
individuals who are associated with a firm and use the technologies in 
communicating with investors?
b. Investor Interaction
    The proposed conflicts rules include definitions for both 
``investor'' and ``investor interaction.'' \126\ For brokers or 
dealers, the definition of investor would include a natural person, or 
the legal representative of such natural person, who seeks to receive 
or receives services primarily for personal, family or

[[Page 53974]]

household purposes. The definition is designed to capture both 
prospective and current retail investors.\127\ For investment advisers, 
the definition of investor would include a client or prospective 
client, and any current or prospective investor in a pooled investment 
vehicle advised by the investment adviser.\128\ The use of PDA-like 
technology by investment advisers of pooled investment vehicles, such 
as algorithmically targeted advertisements that are designed to solicit 
investors in a pooled investment vehicle or algorithmically designed 
investment strategies in pooled investment vehicles, present the same 
investor protection concerns as advisers that use the same or similar 
technology to target or advise their advisory clients. Accordingly, we 
are proposing to define ``investor'' so that the proposed conflicts 
rules would broadly apply both to clients that receive investment 
advisory services from an investment adviser and to investors in a 
pooled investment vehicle advised by the investment adviser.\129\
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    \126\ See proposed conflict rules at (a).
    \127\ See supra note 6. Broker-dealers are subject to regulation 
under the Exchange Act and SRO rules, including a number of 
obligations that attach when a broker-dealer offers services to a 
retail customer, including making recommendations, as well as 
general and specific requirements aimed at addressing certain 
conflicts of interest. The application of these obligations can vary 
depending on a broker-dealer's business lines and activities, as 
well as the level of customer sophistication. See Regulation Best 
Interest, Exchange Act Release No. 83062 (May 9, 2018) [83 FR 21574 
(May 9, 2018)], at 21575 (``Reg BI Proposing Release''); see, e.g., 
FINRA Rule 2210 (applying broker-dealer obligations related to 
communications with the public differently to communications 
directed to retail versus institutional investors). Here, the focus 
of the proposed rules for broker-dealers is on retail investors.
    \128\ See proposed rule 211(h)(2)-4(a) (specifying that ``pooled 
investment vehicle'' has the same meaning as in 17 CFR 275.206(4)-8, 
meaning any investment company as defined in section 3(a) of the 
Investment Company Act of 1940 or any company that would be an 
investment company under section 3(a) of that Investment Company Act 
but for the exclusion provided from that definition by either 
section 3(c)(1) or section 3(c)(7) of the Investment Company Act).
    \129\ See proposed conflict rules at (a) (defining 
``Investor'').
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    The proposed conflicts rules would generally 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.\130\ This 
definition would capture a firm's correspondence, dissemination, or 
conveyance of information to or solicitation of investors, in any form, 
including communications that take place in-person, on websites; via 
smartphones, computer applications, chatbots, email messages, and text 
messages; and other online or digital tools or platforms. This 
definition would include engagement between a firm and an investor's 
account, on a discretionary or non-discretionary basis. This definition 
would also capture any advertisements, disseminated by or on behalf of 
a firm, that offer or promote services or that seek to obtain or retain 
one or more investors. The proposed definition is intended to be 
sufficiently broad to encompass the wide variety of methods, using 
current and future technologies, that firms could use to interact with 
investors.\131\
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    \130\ See proposed conflict rules at (a).
    \131\ See generally Investment Adviser Marketing Release, supra 
note 19 (a recent Commission rule designed to accommodate the 
continual evolution of the use of technology in the investment 
adviser industry as it relates to advisers marketing their services 
to clients and investors).
---------------------------------------------------------------------------

    The proposed definition is generally designed to limit the proposed 
conflicts rules' scope to a firm's use of covered technology in 
interactions with investors. This aspect of the proposed conflicts 
rules recognizes that the conflicts associated with the use of covered 
technology in investor interactions present a higher risk of harm to 
investors than conflicts associated with technologies that are not used 
in such interactions. For instance, a firm could utilize covered 
technology to analyze historical data and current market data to 
identify trends and make predictions related to the firm's intra-day 
liquidity needs, peak liquidity demands, and working capital 
requirements. A firm could likewise use covered technology to make 
investment decisions about its own assets. Similarly, a firm could 
implement covered technology for automation of, for example, ``back 
office'' processes like the routing of customers' orders \132\ and 
accounting and trade settlement. In each of these examples, the use of 
covered technology for these processes does not involve an investor 
interaction, and therefore would not be subject to the proposed 
conflicts rules.
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    \132\ Although routing of customers' orders is not covered by 
this proposal, broker-dealers owe their customers a duty of ``best 
execution.'' Best execution requires that a broker-dealer seek to 
obtain for its customer orders the most favorable terms reasonably 
available in the market under the circumstances. See, e.g., Newton 
v. Merrill, Lynch, Pierce, Fenner & Smith, 135 F.3d 266, 270 (3d 
Cir. 1998). See also Kurz v. Fidelity Management & Research Co., 556 
F.3d 639, 640 (7th Cir. 2009); Geman v. SEC, 334 F.3d 1183, 1186 
(10th Cir. 2003); see also FINRA Rule 5310 (Best Execution and 
Interpositioning). The Commission recently proposed a rule that, if 
adopted, would establish through Commission rule a best execution 
standard for broker-dealers. See Regulation Best Execution, Exchange 
Act Release No. 96496 (Dec. 14, 2022) [88 FR 5440 (Jan. 27, 2023)].
---------------------------------------------------------------------------

    In contrast, when a firm's use or potential use of a covered 
technology in any investor interaction could involve a conflict of 
interest, a firm would be subject to the framework of the proposed 
conflicts rules. The proposed definition of investor interaction does 
not make any distinctions based on the manner in which an investor or 
the investor's account interacts with the covered technology or on the 
manner in which the firm uses the technology in the interaction. 
Meaning, ``use'' of covered technology in an investor interaction can 
occur directly through the use of a covered technology itself (e.g., a 
behavioral feature on an online or digital platform that is meant to 
prompt, or has the effect of prompting, investors' investment-related 
behaviors) or indirectly by firm personnel using the covered technology 
and communicating the resulting information gleaned to an investor 
(e.g., an email from a broker recommending an investment product when 
the broker used PDA-like technology to generate the 
recommendation).\133\
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    \133\ To the extent a broker-dealer uses PDA-like technology to 
make a recommendation to a retail customer, the broker-dealer would 
also be subject to Reg BI and its attendant obligations, including 
the Conflict of Interest Obligation, as to the recommendation. 
Similarly, an investment adviser making a recommendation to its 
client would also be subject to fiduciary obligations that include a 
duty of loyalty under which an adviser must eliminate or make full 
and fair disclosure of all conflicts of interest. See Fiduciary 
Interpretation, supra note 8.
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    Unlike a purely ministerial or back office function, these examples 
involve an investment-related communication with an investor and would 
be considered an investor interaction under the proposed definition. 
Similarly, a firm may use covered technology to provide individual 
brokers or advisers with customized insights into an investor's needs 
and interests and the broker or adviser may use this information to 
supplement their existing knowledge and expertise when making a 
suggestion to the investor during an in-person meeting. Such a scenario 
would result in the firm using a covered technology in an investor 
interaction under the proposed rules. An investor interaction would 
also include firms' use of game-like prompts or marketing that 
``nudge'' investors to take particular investment-related actions on 
digital platforms. In addition, the investor interaction definition 
covers solicitations, for example, a firm utilizing covered technology 
that scrapes public data, which the firm in turn uses to solicit 
clients through broadcast emails.\134\
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    \134\ See infra section II.A.2.e (acknowledging that although a 
firm's use of covered technology to solicit investors to open an 
account falls under the definition of an investor interaction, it 
may not involve a conflict of interest that would require 
elimination or neutralization under the proposed conflicts rules). 
On the other hand, a conflict of interest may appear if a firm's 
chatbot is programmed to solicit only investors that scraped data 
show are heavy gamblers, and thus perceived as being more profitable 
to the firm as investors that might invest in risky, high-profit 
investments that earn the firm more money relative to other 
investments.

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[[Page 53975]]

    The proposed definition of investor interaction would include 
interactions that have generally been viewed as outside the scope of 
``recommendations'' for broker-dealers.\135\ For example, under the 
proposed definition, an investor interaction could include: firms' use 
of research pages or ``electronic libraries'' to provide investors with 
the ability to obtain or request research reports, news, quotes, and 
charts from a firm-created website; or firm's use of technologies to 
generate emails to investors as part of a firm-run email communication 
subscription that investors can sign up for and customize, and which 
alerts investors to items such as news affecting the securities in the 
investor's portfolio or on the investor's ``watch list.'' \136\ 
Accordingly, the proposed definition would capture firm communications 
that may not rise to the level of a recommendation, yet are nonetheless 
designed to, or have the effect of, guiding or directing investors to 
take an investment-related action.
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    \135\ See NASD Notice to Members 01-23 (Apr. 2001) (Online 
Suitability--Suitability Rules and Online Communications) 
(discussing the types of online communications may constitute 
``recommendations'' under the NASD suitability rule); Reg BI 
Adopting Release, supra note 8, at section II.B.2 (discussing 
factors to consider when determining whether a ``recommendation'' 
has been made by a broker-dealer).
    \136\ See NASD Notice to Members 01-23, id.
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    The proposed definition would exclude from the investor interaction 
definition interactions solely for purposes of meeting legal or 
regulatory obligations.\137\ 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. For example, the proposed 
definition would exclude interactions with investors solely for anti-
money laundering purposes, such as using PDA-like technologies to 
identify and track investor activity for the purposes of flagging 
suspected fraudulent transactions and requesting identification and 
verification of the transaction from an investor (e.g., sending two-
factor authentication messages).\138\ If a firm, however, includes as 
part of such an interaction actions that are not reasonably designed to 
satisfy its obligations under applicable law (e.g., circulating a link 
to a digital platform that includes features designed to prompt 
investors to trade along with the annual delivery of Form ADV), and 
such additional actions are otherwise within the definition of an 
investor interaction, then such action would be considered an investor 
interaction for purposes of the proposed conflicts rules.
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    \137\ See proposed conflicts rules at (a).
    \138\ The activities covered under this legal and regulatory 
obligation exception would qualify as an investor interaction that 
uses covered technology absent this exception. However, as a 
practical matter, many of these activities would not involve a 
firm's use of covered technology under the proposed definition, 
because such activities would not involve an analytical, 
technological, or computation function, algorithm, model, 
correlation matrix, or similar method or process (e.g., delivery of 
Form ADV or summary prospectus pursuant to legal obligations).
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    In addition, the proposed definition would also exclude 
interactions solely for purposes of providing clerical, ministerial, or 
general administrative support. For example, the proposed definition 
would exclude basic chatbots or phone trees that firms use to direct 
customers to the appropriate customer service representative. This 
aspect of the exclusion is only intended to cover basic or first-level 
customer support designed to efficiently answer simple questions like 
providing the business hours of a branch office or the balance in the 
investor's account, or to guide the investor to a human representative 
in the appropriate department of the firm who is trained to address the 
investor's question. On the other hand, if a firm sought to employ a 
more advanced chatbot designed to answer complex investment-related 
questions, such as when or whether to invest in a particular investment 
product or security, this would no longer fit within the exclusion for 
clerical, ministerial, or general administrative support, and would 
constitute an investor interaction under the proposed definition.
    In either case, the exclusions would be limited to interactions 
that are ``solely for the purpose'' of the relevant category (or 
categories) of conduct in order to help ensure that interactions that 
serve several purposes, including purposes that are not excluded, will 
be within the scope of the definition of investor interaction.\139\ The 
``solely for the purpose'' language is designed to help ensure that all 
the functions of a dual-use technology like a chatbot would be 
considered when evaluating conflicts of interest associated with use of 
the chatbot.
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    \139\ Interactions that are for the purpose of both categories 
of conduct would also fit within the exclusion. For example, an 
algorithm whose purpose was both to comply with legal or regulatory 
obligations and to conduct other clerical, ministerial, or general 
administrative support functions would fit within the exclusion so 
long as the algorithm did not also have a third purpose that was not 
excluded from the definition.
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    We request comment on all aspects of the proposed definitions of 
investor interaction and investor, including the following items:
    10. For broker-dealers, the proposed definition of investor means a 
natural person, or the legal representative of such natural person, who 
seeks to receive or receives services from the broker-dealer primarily 
for personal, family or household purposes. Should we narrow the 
definition of investor as applied to broker-dealers to only cover 
retail customers, as defined under Reg BI? Should we expand the 
definition of investor for brokers or dealers to cover all current and 
prospective investors and not just retail investors? We have stated 
that investors may not be able to understand the complexities of 
covered technologies and any conflicts associated with their use. 
Should we expand the definition of investor for broker-dealers to cover 
a certain subset of non-retail investors? The proposed definition of 
investor for investment advisers is not limited to services ``primarily 
for personal, family or household purposes.'' Should we add such 
limitation in the investment adviser conflicts rule?
    11. Should we narrow the definition of investor for investment 
advisers? For example, should we only apply it to retail investors, as 
defined in Form CRS? If so, please explain why in comparison to other 
rules under the Advisers Act.
    12. For investment advisers, the proposed definition of investor 
also includes investors or prospective investors in a pooled investment 
vehicle that is a client or prospective client of the investment 
adviser; should we retain this in the final rules? Are there special 
considerations for investors in a pooled investment vehicle that cause 
them to need less protection from conflicts of interest associated with 
a firm's use of covered technology? If the definition of ``investor'' 
continues to include investors in pooled investment vehicles, as 
proposed, are there certain structures or types of pooled investment 
vehicles that should not be included? For example, should investors in 
collateralized loan obligation vehicles be excluded? Are there unique 
characteristics of such vehicles,

[[Page 53976]]

investors, or investors in other pooled investment vehicles, which make 
the additional protections that would be provided by the proposed 
conflicts rules unnecessary? The proposed definition of ``investor'' 
would incorporate the definition of ``pooled investment vehicle'' in 
rule 206(4)-8. Should we define the term ``pooled investment vehicle'' 
(or use another term)? Should we define the term more broadly for 
purposes of this rule to include other vehicles to which an investment 
adviser may provide investment advice that rely on other exclusions 
from the definition of investment company, such as companies primarily 
engaged in holding mortgages that are excluded pursuant to section 
3(c)(5)(C) of the Investment Company Act, or collective investment 
trust funds or separate accounts excluded under section 3(c)(11) of the 
Investment Company Act?
    13. Will the proposed definition of investors present challenges 
for firms that are dually registered as investment advisers and broker 
dealers?
    14. Should we define ``prospective investor'' in the proposed 
rules? If so, how should we define this term and why? For example, 
should we define ``prospective investor'' as any person or entity that 
engages in some way with a firm's services (e.g., downloads the firm's 
mobile app, visits the firm's website, or creates a log-in)? If not, 
should we provide guidance regarding how firms can identify prospective 
investors?
    15. Is the proposed definition of investor interaction sufficiently 
clear? Would firms be able to identify what would be an investor 
interaction for purposes of the proposed conflicts rules? Are there 
activities that are not covered by the proposed definition of investor 
interaction that should be? Are there activities that are covered by 
the proposed definition that should not be? For instance, should a firm 
soliciting prospective investors be included within the definition? 
Should the proposed definition be limited to interactions in which 
investors directly interact with, or otherwise directly use, covered 
technology? Do situations in which investors do not directly interact 
with covered technology raise the same concerns of scalability as those 
in which investors do interact directly?
    16. Do commenters agree that investor interactions, as proposed, 
may entail conflicts of interest that are particularly likely to result 
in investor harm or to take additional effort to discern? Are there 
types of activities we should specifically include or exclude within 
the definition?
    17. Do commenters agree that the definition of investor interaction 
should exclude interactions solely for purposes of meeting legal or 
regulatory obligations or providing clerical, ministerial, or general 
administrative support? Should we remove any or all aspects of these 
exclusions from the definition in the final conflicts rules? In the 
case of interactions solely for the purpose of meeting legal or 
regulatory obligations, should we broaden or narrow the exclusion? For 
example, should we take into account legal or regulatory obligations as 
a result of compliance with foreign law, or with policies, rules, or 
directives of SROs (including securities exchanges) or other bodies? 
Generally, would investor interactions that fall under the proposed 
exclusions employ covered technology (e.g., technologies that optimize 
for, predict, guide, forecast, or direct investment-related behaviors 
or outcomes)? If so, how? If not, is the exception for legal or 
regulatory obligations additive? Is the exclusion for providing 
clerical, ministerial, or general administrative support sufficiently 
clear? For instance, is it clear this phrasing would capture trade 
settlement and the routing of customers' orders or would further 
explanation be helpful?
    18. Do the proposed conflicts rules adequately address how a firm 
would treat a single covered technology that features functions that 
are both included and excluded from the investor interaction 
definition? For instance, a chatbot that is used for both general 
customer support help (e.g., password resets) and to provide more 
advanced functions, such as guiding an investor as to when and whether 
to invest in a particular investment product. Should the proposed 
conflicts rules treat these dual-purpose covered technologies 
differently than covered technology used solely for purposes of meeting 
legal or regulatory obligations or providing clerical, ministerial, or 
general administrative support?
    19. To the extent we retain or expand the exclusions, are there any 
conditions we should add in order for a firm to be able to rely on 
particular exclusions? For example, should we require that a firm 
create and maintain a written record if it relies on an exclusion? Are 
there other activities that should be excluded? For example, should we 
provide a more principles-based exclusion for certain activities that 
the firm affirmatively identifies in writing as low-risk and that are 
already part of existing compliance programs or subject to other laws, 
rules, regulations, or policies?
    20. As specified in the proposed definition of investor 
interaction, the definition would include discretionary management of 
accounts where the engagement is with the investor's account, even if 
there is no communication or other interaction with investors 
themselves at the time of trades in their accounts. Should the 
discretionary management of accounts be included within the definition 
of investor interaction? Should it be excluded? Do commenters agree 
that a firm's discretionary management of accounts using covered 
technologies may entail conflicts of interest that are particularly 
likely to result in investor harm and are not sufficiently addressed 
under the current applicable legal framework? Why or why not?
2. Identification, Determination, and Elimination, or Neutralization of 
the Effect of, a Conflict of Interest
    The proposed conflicts rules would require a firm to eliminate, or 
neutralize the effect of, certain conflicts of interest associated with 
the use of a covered technology in investor interactions.\140\ The 
proposed conflicts rules would also require firms to take affirmative 
steps as a precursor to eliminating or neutralizing the effect of these 
conflicts. First, a firm would be required to evaluate any use or 
reasonably foreseeable potential use of a covered technology in any 
investor interaction to identify whether it involves a conflict of 
interest, including through testing the technology. Second, a firm 
would be required to determine if any such conflict of interest results 
in an investor interaction that places the interest of the firm or an 
associated person ahead of investors' interests. Third, the proposed 
conflicts rules would require a firm to take a particular action--
elimination or neutralization--to address any conflict of interest the 
firm determines in step two results in an investor interaction that 
places its or an associated person's interest ahead of investors' 
interests.\141\ The proposed conflicts rules thus supplement, rather 
than supplant, existing regulatory obligations related to conflicts of 
interest, laying out particular steps a firm must take to address 
conflicts of interest arising specifically from the use of covered 
technologies in investor interactions.\142\

[[Page 53977]]

This is because the nature of these technologies (for example due to 
their inherent complexity and ability to rapidly scale transmission of 
conflicted actions across a firm's investor base) requires additional 
steps to address conflicts associated with their use in investor 
interactions, compared to conflicts of interest more generally.
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    \140\ See infra section II.A.2.e.
    \141\ On the application to interests of associated persons, see 
infra sections II.A.2.c, II.A.2.d, and II.A.2.e, and proposed 
conflicts rules at (b)(2) and (3).
    \142\ The elimination or neutralization requirement of the 
proposed rules applies only to a narrower, defined subset of the 
broader universe of conflicts--those conflicts that a firm 
determines actually place the interests of the firm or certain 
associated persons ahead of the interests of investors. This is in 
contrast to, for example, an investment adviser's fiduciary duty, 
which encompasses any interest that might incline the adviser, 
consciously or subconsciously, to provide advice that is not 
disinterested., or similarly in contrast to the broader universe of 
conflicts covered by Reg BI. Other conflicts of interest that only 
might affect the firm's investor interactions would continue to be 
subject to these other obligations, as applicable.
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a. Evaluation and Identification
    The proposed conflicts rules would require a firm to evaluate any 
use or reasonably foreseeable potential use by the firm or its 
associated persons of a covered technology in any investor interaction 
to identify any conflict of interest associated with that use or 
potential use.\143\ This requirement of the proposal, in connection 
with the requirement to test and periodically retest any covered 
technology, is designed to help ensure that a firm has a reasonable 
understanding of whether its use or reasonably foreseeable potential 
use of the covered technology in investor interactions would be 
associated with a conflict of interest.
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    \143\ See proposed conflicts rules at (b)(1).
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    The proposed conflicts rules do not mandate a particular means by 
which a firm is required to evaluate its particular use or potential 
use of a covered technology or identify a conflict of interest 
associated with that use or potential use. Instead, the firm may adopt 
an approach that is appropriate for its particular use of covered 
technology, provided that its evaluation approach is sufficient for the 
firm to identify the conflicts of interest that are associated with how 
the technology has operated in the past (for example, based on the 
firm's experience in testing or based on research the firm conducts 
into other firms' experience deploying the technology) and how it could 
operate once deployed by the firm. If a technology could be used in a 
variety of different scenarios, the firm should consider those 
scenarios in which it intends that the technology be used (and for 
which it is conducting the identification and evaluation process). It 
should also consider other scenarios that are reasonably foreseeable 
unless the firm has taken reasonable steps to prevent use of the 
technology in scenarios it has not approved (for example, by limiting 
the personnel who are able to access the technology).
    A firm could adopt different approaches for different covered 
technologies.\144\ Such approaches could vary depending on the nature 
of the covered technologies employed by the firm at the time they are 
implemented, how the technologies are used, and the firm's plans for 
future use of those technologies. For example, a firm that only uses 
simpler covered technologies in investor interactions, such as basic 
financial models contained in spreadsheets or simple investment 
algorithms, could take simpler steps to evaluate the technology and 
identify any conflicts of interest, such as requiring a review of the 
covered technology to confirm whether it weights outcomes based on 
factors that are favorable for the adviser or broker-dealer, such as 
the revenue generated by a particular course of action.\145\ Even when 
a firm identifies a conflict of interest associated with a simple 
covered technology, depending on the facts and circumstances, it may 
determine that such conflict of interest does not actually result in 
the firm's or an associated person's interests being placed ahead of 
those of investors, and that the conflict of interest does not need to 
be eliminated or its effects to be neutralized.
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    \144\ Cf. U.S Chamber of Commerce Technology Engagement Center, 
Report of the Commission on Artificial Intelligence Competitiveness, 
Inclusion, and Innovation (Mar. 9, 2023), at 82 (``Chamber of 
Commerce AI Report''), https://www.uschamber.com/assets/documents/CTEC_AICommission2023_Report_v6.pdf (calling for ``impact 
assessments'' to help categorize potentially harmful uses of certain 
technologies in a risk-based framework).
    \145\ See infra section II.A.2.d, discussing financial models.
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    Firms that use more advanced covered technologies may need to take 
additional steps to evaluate technology adequately and identify 
associated conflicts adequately.\146\ For example, a firm might 
instruct firm personnel with sufficient knowledge of both the 
applicable programming language and the firm's regulatory obligations 
to review the source code of the technology, review documentation 
regarding how the technology works, and review the data considered by 
the covered technology (as well as how it is weighted).\147\ A firm 
seeking to evaluate an especially complex covered technology and 
identify conflicts of interest associated with its use may consider 
other methods as well. For example, if a firm is concerned that it may 
not be possible to determine the specific data points that a covered 
technology relied on when it reached a particular conclusion, and how 
it weighted the information, the firm could build ``explainability'' 
features into the technology in order to give the model the capacity to 
explain why it reached a particular outcome, recommendation, or 
prediction.\148\ By reviewing the output of the explainability 
features, the firm may be able to identify whether use of the covered 
technology is associated with a conflict of interest.\149\ Developing 
this capability would require an understanding of how the model 
operates and the types of data used to train it.
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    \146\ These steps could be included in the policies that the 
firm would be required to adopt under the proposed conflicts rules, 
and may also be necessary to satisfy the proposed recordkeeping 
amendments. See infra section II.A.3 and II.B. A written description 
of a covered technology prepared in accordance with policies and 
procedures that are reasonably designed to prevent violation by the 
firm of the proposed conflicts rules generally should include a 
written evaluation of the technology and identify any conflicts of 
interest presented by the technology. This would also assist the 
firm in preparing records that would comply with the proposed 
recordkeeping amendments. See infra section II.B.
    \147\ When evaluating the data considered by a covered 
technology used by a firm, both the data itself and the weighting of 
the data may inform a firm's determination of whether or not any 
conflict of interest it identifies and evaluates would result in an 
investor interaction that places the interest of the firm ahead of 
the interests of investors. See infra section II.A.2.d.
    \148\ See supra section I.B.4 (describing complex or opaque 
technologies, sometimes referred to as ``black boxes'').
    \149\ Testing (such as A/B testing) that is designed to 
determine the influence of a particular factor may also be helpful 
and is discussed infra. If the output of the explainability features 
is not sufficient for the firm to identify whether a conflict of 
interest exists at all, the firm may still be able to use the output 
to determine that any conflict of interest that may exist still does 
not result in its interests being placed ahead of investors' 
interests, or alternatively that any conflicts of interest that may 
exist have been eliminated or their effect has been neutralized due 
to controls the firm placed on its use of the technology. See infra 
section II.A.2.d (discussing using explainability features for 
determination) and infra section II.A.2.e (discussing using 
explainability features for elimination or neutralization).
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    Not all of these steps would be necessary (or possible) in all 
circumstances. So long as the firm has taken steps that are sufficient 
under the circumstances to evaluate its use or reasonably foreseeable 
potential use of the covered technology in investor interactions and 
identify any conflicts of interest associated with that use or 
potential use, this aspect of the proposed conflicts rules would be 
satisfied. To the extent a technology is customizable, we anticipate a 
firm will be able to evaluate the technology and identify the conflicts 
associated with its use through the choices it makes when customizing 
the technology. For

[[Page 53978]]

technologies that are not customizable, we anticipate a firm will be 
able to evaluate the technology and identify conflicts via other means.
    For example, a firm that licenses a covered technology from a third 
party may have no access, or limited access, to the underlying source 
code of the technology. In such circumstances, provided that the other 
documentation regarding how the technology functions is sufficiently 
detailed as to how the technology works, the identification and 
evaluation could be satisfied through review of such documentation. 
Firms without access to the underlying source code could review, for 
example, documentation about how the technology can be tailored to its 
investors' requirements (such as how to tailor it to eliminate, or 
neutralize the effect of, conflicts of interest). In circumstances 
where the firm is relying only on the technology's documentation, its 
testing methodology would be of special importance to help the firm 
discover whether there is any undocumented functionality that could be 
associated with a conflict of interest.
    When evaluating a covered technology and identifying conflicts of 
interest, a firm should consider the circumstances in which a covered 
technology would be deployed in investor interactions. Firms that use a 
covered technology in investor interactions that operates autonomously 
or with limited involvement by firm personnel should consider 
subjecting it to more scrutiny because the firm's personnel may not 
immediately notice if the conflicts become apparent once the technology 
is deployed, or if its outputs change over time.\150\ On the other 
hand, if a covered technology is only used to provide first drafts of 
marketing materials, or is only used to provide investment ideas that 
will be more fully considered by firm personnel who are trained on the 
firm's compliance policies, and the drafts or ideas are subjected to 
scrutiny throughout the review process before the output is ultimately 
used in an investor interaction, the covered technology generally may 
need comparatively less scrutiny.
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    \150\ This tendency would also mean that the technology would 
need to be tested on a more frequent basis. See infra section 
II.A.2.b (discussing proposed testing requirement as it would apply 
to technologies that ``drift'' or that operate autonomously).
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    In certain cases, it may be difficult or impossible to evaluate a 
particular covered technology or identify any conflict of interest 
associated with its use or potential use within the meaning of the 
proposed rules. For example, many large language models may consider 
millions of different data points, which could make it difficult for a 
firm to determine whether certain of those data points implicate the 
firm's interest. In some cases, it may be difficult for the firm to 
understand exactly what is in the data set that the model is 
considering, for example, if it was trained on a data set from the 
entire internet. Likewise, there may be situations where a firm does 
not have full visibility into all aspects of how a covered technology 
functions, such as if the firm licensed it from a third party.\151\ 
However, a firm's lack of visibility would not absolve it of the 
responsibility to use a covered technology in investor interactions in 
compliance with the proposed conflicts rules.
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    \151\ FINRA has stated that outsourcing an activity or function 
to a third-party vendor does not relieve broker-dealers of their 
supervisory obligations, which must be reasonably designed to 
achieve compliance with Federal securities laws and regulations, as 
well as FINRA rules. See Vendor Management and Outsourcing, FINRA 
Regulatory Notice 21-29 (Aug. 13, 2021), https://www.finra.org/sites/default/files/2021-08/Regulatory-Notice-21-29.pdf. We also 
recently proposed a rule that, if adopted, would govern outsourcing 
by investment advisers of certain covered functions, and would in 
certain cases require investment advisers to obtain reasonable 
assurances that third parties could meet certain standards required 
by the Advisers Act and the rules thereunder. See Proposed 
Outsourcing Rule, supra note 124.
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    The Commission is aware that some more complex covered technologies 
lack explainability as to how the technology functions in practice, and 
how it reaches its conclusions (e.g., a ``black box'' algorithm where 
it is unclear exactly what inputs the technology is relying on and how 
it weights them). The proposed conflicts rules would apply to these 
covered technologies, and firms would only be able to continue using 
them where all requirements of the proposed conflicts rules are met, 
including the requirements of the evaluation, identification, testing, 
determination, and elimination or neutralization sections. For example, 
as a practical matter, firms that use such covered technologies likely 
may not meet the requirements of paragraph (b) of the proposed 
conflicts rules where they are unable to identify all conflicts of 
interest associated with the use of such covered technology. However, 
in such cases, firms may be able to modify these technologies, for 
example by embedding explainability features into their models and 
adopting back-end controls (such as limiting the personnel who can use 
a technology or the use cases in which it could be employed) in a 
manner that will enable firms to satisfy these requirements.
    We request comment on all aspects of the proposed conflict rules' 
identification and evaluation requirement, including the following 
items:
    21. Do the proposed conflicts rules' identification and evaluation 
requirements complement, overlap with, or duplicate the existing 
regulatory framework for broker-dealers and investment advisers? If so, 
in what ways? Specifically, would firms' compliance with those other 
regulatory requirements contribute to compliance with the proposed 
conflicts rules, and vice versa?
    22. Is the proposed requirement that a firm evaluate any use or 
reasonably foreseeable potential use of a covered technology to 
identify any conflict of interest associated with that use or potential 
use sufficient for a firm to understand how it should comply with the 
proposed conflicts rules? Should firms only be required to evaluate a 
technology used in investor interactions and identify associated 
conflicts of interest if they reasonably believe their use (or 
potential use) of the technology could be associated with a conflict of 
interest that results in their interest being placed ahead of 
investors' interests? Absent the evaluation and identification required 
under the proposed rule, how would firms form such a reasonable belief? 
Should we use some other standard, such as a good faith, recklessness, 
or actual knowledge standard, or some other option? Would such a 
standard be sufficient to protect investors from the potential harmful 
impact of conflicts of interest? Is the requirement sufficiently 
general that it would continue to apply to future technologies with 
features we may not currently anticipate? If we were to provide 
additional clarity (whether through guidance or by changing the 
regulatory text), how should we ensure that the rule's requirement to 
identify and evaluate these conflicts is sufficiently general that it 
would continue to apply to future technologies with features or 
functionality that we may not currently anticipate? Should we define 
the terms ``identify'' or ``evaluate'' in the regulatory text and, if 
so, how should they be defined? Should we use different terms to 
address this concept and, if so, which terms and how should they be 
defined?
    23. The identification and evaluation requirement would also 
require firms to identify and evaluate conflicts of interest associated 
with use or potential use of a covered technology by an associated 
person; what challenges, if

[[Page 53979]]

any, would firms face due to this aspect of the proposed conflicts 
rules? Should we make any changes as a result? For example, should we 
limit the scope of the requirement to conflicts of interest of which 
the firm is aware or reasonably should be aware or should we limit the 
scope to any conflict that is reasonably foreseeable? Instead of or in 
addition to covering conflicts of interest associated with firms' 
associated persons' use of covered technologies, should we prescribe 
any additional requirements, such as additional diligence or policies 
and procedures, relating to conflicts of interest associated with 
firms' associated persons' use of covered technologies? The proposed 
conflicts rules would consider conflicts of associated persons only for 
associated persons that are individuals, and not of entities that 
control, are controlled by, or are under common control with a firm, 
but many of the Commission's enforcement actions relating to 
undisclosed conflicts have involved conflicts of firms' affiliated 
entities, and not of individuals.\152\ In addition to natural persons, 
should we broaden the requirement to cover entities controlling, 
controlled by, or under common control with firms?
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    \152\ See, e.g., In re. Charles Schwab & Co, supra note 89.
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    24. Do the proposed conflicts rules provide appropriate clarity 
around when a firm uses covered technology in an investor interaction? 
For instance, is the guidance included in this release clear that the 
proposed conflicts rules would not distinguish between a firm directly 
using a covered technology in an investor interaction, such as when an 
investor interfaces with the covered technology without an intermediary 
of the firm, and when a firm uses covered technology indirectly in an 
investor interaction, such as where staff of the firm receives the 
output and communicates it to the investor? Do commenters agree with 
this scope? Should we instead exclude ``indirect'' use in investor 
interactions? Alternatively, should we include indirect uses in 
investor interactions but apply the rule differently? If so, what 
safeguards, if any, would be necessary or appropriate for indirect uses 
in investor interactions? As an example, should the rule make a 
distinction between an investor interaction using a covered technology 
itself (e.g., a behavioral feature on a digital platform) and an 
investor interaction in which the firm uses covered technology 
indirectly (e.g., a broker emailing a recommendation that it generated 
using AI-tools)? Should we revise the rule text to explicitly include 
``indirect'' investor interactions, for example by adding the phrase 
``directly or indirectly''? Alternatively, should the rule text include 
a definition of ``use'' within the context of a firm's use of a covered 
technology in an investor interaction?
    25. How can scalability rapidly exacerbate the magnitude and 
potential effect of the conflict in a way that could make full and fair 
disclosure and informed consent unachievable or more difficult? Does 
this depend on who the investors are (e.g., individuals versus 
entities)? Is it possible to disclose conflicts that are associated 
with the use of certain covered technologies in a manner that would 
enable investors to understand and provide consent? What are the 
characteristics of such technologies, and how do they differ from PDA-
like technologies? How should the final conflicts rules account for 
such technologies? For instance, should certain uses of covered 
technologies by firms not be subject to the identification, 
determination, and elimination or neutralization requirements in the 
proposed conflicts rules? Should we permit firms to provide disclosure 
regarding their use of such technologies as an alternative method of 
complying with the proposed conflicts rules? If so, should the final 
rules contain principles pursuant to which firms would decide whether 
and how they are able to disclose the conflicts? Should the Commission 
instead adopt disclosure standards or criteria? What would those 
disclosure standards or criteria entail? For example, should one such 
standard be that the technology is easily understandable to laypersons? 
What would constitute ``easily understandable to laypersons''? 
Alternatively, should the Commission set out different classes of 
conflicts of interest or different classes of covered technologies and 
prescribe different ways to address each such conflicts or 
technologies?
    26. Are there particular methods that firms use to identify and 
evaluate conflicts of interest that we should discuss in the proposed 
conflicts rules? Should we describe particular methods of 
identification and evaluation that would comply with the rules? If we 
were to address such methods specifically, how would we ensure that the 
rule continues to apply to new technologies and new types of investor 
interactions as they develop?
    27. How widespread is the use of ``black box''-type models 
currently? Under existing law, do firms believe that it is possible to 
use black box technologies in compliance with the applicable standard 
of conduct and, if so, what steps do they take to comply with the 
applicable standard of conduct? How will firms using black box 
technologies meet the requirements of the proposed conflicts rules? 
Will this require significant changes in firms' practices? What 
challenges would firms face when identifying and evaluating conflicts 
of interest associated with black box technologies, where the outputs 
do not always make clear which inputs were relied on, and how those 
inputs were weighted? Are there situations where firms are not able 
conclusively to identify and evaluate all potential conflicts of 
interest associated with a covered technology, including because it is 
a black box? How prevalent are these situations? Will they be able to 
identify and evaluate whether a firm interest is being considered, or 
to determine whether such interest is being placed ahead of the 
interests of investors? Instead of or in addition to the proposed 
requirements, should we explicitly require that any technologies used 
by firms be explainable? Is our understanding correct that firms could 
build ``explainability'' features into the technology in order to give 
the model the capacity to explain why it reached a particular outcome, 
recommendation, or prediction?
    28. How will firms conduct conflict of interest identification and 
evaluation using personnel who are well-trained on both the inner 
workings of covered technologies used in investor interactions and how 
to identify common conflicts of interest under the applicable standard 
of conduct? Are there other methods firms may use, such as third-party 
consultants and, if so, should we explicitly address these other 
methods? For example, should we explicitly permit or require a firm to 
rely on an analysis prepared by a third party identifying and 
evaluating the conflicts of interest that could be associated with a 
particular covered technology? If we were to explicitly address third-
party analyses, are there particular situations we should address? For 
example, should we permit firms to rely on analyses by developers of 
covered technologies that are licensed to firms? What standards would 
be necessary in order for a firm to reasonably rely on a third-party 
analysis? For example, should a third-party analyst be required to 
demonstrate a particular level of expertise, possess a particular 
credential, certification, or license, or be independent from the 
developer of the technology or the firm relying on the analysis? How 
should firms address situations where the underlying source code is not 
available

[[Page 53980]]

or is incomplete, or where it is very complex?
    29. When firms license covered technologies used in investor 
interactions, is the available documentation sufficient for them to 
determine whether such technologies present conflicts of interest? Is 
review of such documentation sufficient for a firm to identify and 
evaluate conflicts of interest?
b. Testing
    As part of the identification and evaluation requirement, the 
proposed conflicts rules would include a requirement to test each 
covered technology prior to its implementation or material 
modification, and periodically thereafter, to determine whether the use 
of such covered technology is associated with a conflict of 
interest.\153\ This obligation would help ensure that conflicts of 
interest that may harm investors are identified in light of how the 
covered technology actually operates. For example, such testing may 
surface additional information that would not be apparent simply from 
reviewing the source code or documentation for the covered technology 
or the underlying data it uses. It may also surface pre-existing 
business practices of a firm where the firm considers firm-favorable 
information in its interactions with investors, and the firm's use of 
covered technology that replicates such business practices is 
associated with a conflict of interest by causing the technology to 
consider such firm-favorable information.
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    \153\ Proposed conflicts rules at (b)(1). Testing would only be 
required by the proposed conflicts rules as part of the 
identification and evaluation prong of the rules. As a practical 
matter, some firms that believe they have eliminated, or neutralized 
the effect of, conflicts of interest associated with their use of a 
covered technology may wish to confirm this through testing. See 
infra section II.A.2.e (describing elimination and neutralization).
---------------------------------------------------------------------------

    Although the proposed rules would not specify any particular method 
of testing or frequency of retesting that the firm must conduct, there 
are two specific times testing is required. A firm would be required to 
conduct testing prior to the covered technology being implemented.\154\ 
A firm also would be required to conduct testing before deploying any 
``material modification'' of the technology, such as a modification to 
add new functionality like expanding the asset classes covered by the 
technology. We would not generally view minor modifications, such as 
standard software updates, security or other patches, bug fixes, or 
minor performance improvements to be a ``material modification.'' 
During the time that the material modifications are being tested, a 
firm could continue to use an older version of the covered technology 
if the firm's use of such previous version of the technology complies 
with the proposed conflicts rules.
---------------------------------------------------------------------------

    \154\ See infra section II.A.2.e for additional information 
regarding drift.
---------------------------------------------------------------------------

    The proposed requirement to retest a covered technology 
periodically does not specify how often retesting would be required. As 
a result, a firm also would need to determine how often, and the manner 
in which, to retest covered technologies used in investor 
interactions.\155\ As with the proposed identification and evaluation 
requirement, a firm's testing methodologies and frequencies may vary 
depending on the nature and complexity of the covered technologies it 
deploys. Relatively simple or easy-to-understand covered technologies 
where the risk of a conflict of interest is low could be subject to 
similarly simple testing protocols, and such testing could even take 
place concurrently with the firm's efforts to identify and evaluate any 
conflicts of interest associated with the covered technology. For 
example, firms that use relatively straightforward technology may 
determine that it is appropriate to expend the majority of their 
testing efforts when technology is first implemented (i.e., first 
deployed) or when it is substantially modified, and any periodic 
testing may focus only on a sampling of the firm's covered 
technologies.
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    \155\ Though the policies and procedures requirement of the 
proposed conflicts rules would not explicitly require a firm to 
specify how often it would retest its covered technologies, as a 
practical matter, many firms may find it easier to comply with the 
requirement to retest their covered technologies periodically by 
implementing a policy to guide firm personnel.
---------------------------------------------------------------------------

    On the other hand, firms that use complex covered technologies 
generally should use testing methodologies and frequencies that are 
tailored to this complexity and that are based on a review of the 
particular features that make the technologies more or less likely to 
involve a conflict of interest. For example, a firm may determine that 
it is necessary to use specific testing methodologies for certain 
complex covered technologies. Some covered technologies may need to be 
tested using A/B testing to determine what factors are being optimized, 
to determine whether any of those factors are the firm's interests (or 
act as proxies for the firm's interests), or to estimate the effect of 
the methodology with and without the factors that involve the firm's 
interests.\156\ Firms may also choose to review data about a 
technology's historical performance to monitor signs that it may be 
optimizing for firm-favorable factors.
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    \156\ See Seldon, supra note 74. Though the testing requirement 
is contained in section (b)(1) of the proposed conflicts rules, 
testing could also be used to aid compliance with other aspects of 
the proposed conflicts rules. For example, as discussed infra, 
testing may assist a firm in the determination process in section 
(b)(2) of the proposed conflicts rules or the elimination and 
neutralization process in section (b)(3) of the proposed conflicts 
rules.
---------------------------------------------------------------------------

    Likewise, certain learning models are prone to ``drift'' or 
``decay,'' which can occur when the data the models were trained on 
differs from the data that they encounter once deployed, and their 
outputs differ from what would be expected because the training data 
did not account for such difference. When models are constantly 
optimized, this can result in a feedback loop that, over time, 
magnifies small biases and causes the outputs to differ from what would 
be expected.\157\ If a model has experienced drift, the drift, on its 
own, would not constitute a material modification. But if a firm is 
aware that a model is prone to drift (e.g., due to information 
developed during the evaluation and identification stage, or through 
review of the technology's documentation), the firm would need to take 
this into account as it complied with other aspects of the proposed 
conflicts rules in order to help ensure that the steps it took to 
comply with the proposed rules were effective. A firm that uses covered 
technologies that exhibit this phenomenon may determine that it is 
necessary to test the technology more frequently to determine if it 
continues to function in accordance with the proposed conflict rules, 
even if the covered technology has not been modified by the firm. The 
same may be true for covered technologies that function with limited 
involvement from firm personnel, since otherwise firm personnel may not 
immediately notice any changes in how the technology functions.
---------------------------------------------------------------------------

    \157\ See AI Infrastructure Alliance, Everything You Need to 
Know about Drift in Machine Learning (May 25, 2022), https://ai-infrastructure.org/everything-you-need-to-know-about-drift-in-machine-learning/.
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    As firms consider appropriate timing and manner of retesting, they 
should consider the nature and complexity of the technology. For 
example, a firm may determine to test relatively uncomplicated 
technology or technology used only for interactions that are subject to 
numerous other compliance controls less frequently than it would test a 
very complex technology that interacts directly with investors

[[Page 53981]]

without any other human interaction. A firm should also consider 
whether covered technology continues to be used as intended and as 
originally tested. For example, if a firm originally develops a 
technology only for a limited purpose, but then begins to use the 
technology in additional investor interactions that differ 
substantially from the original use case, the firm may determine it is 
necessary to retest the technology with respect to this new use case in 
order to determine whether any unforeseen conflicts arise as a result.
    We request comment on all aspects of the proposed conflicts rules' 
testing requirement, including the following items:
    30. Is the proposed requirement to test covered technologies used 
in investor interactions prior to implementation sufficiently clear? 
For example, are there circumstances where it would not be apparent 
when a technology has been ``implemented'' for purposes of the proposed 
conflicts rules? Should we specifically define the term 
``implementation,'' for example by defining it to mean the first time 
the technology is used in investor interactions? If a firm deploys a 
covered technology on a ``pilot'' basis to a limited group of users, 
should this not be considered to be an ``implementation'' for purposes 
of the proposed conflicts rules, even if the technology is used in 
investor interactions? If we were to provide such an exclusion, what 
additional safeguards should be required? For example, should firms 
seeking to rely on this exclusion be required to subject the covered 
technology to enhanced oversight, such as requiring regular reports on 
how the technology is being used, requiring members of the pilot group 
to determine independently whether their use of the technology is 
resulting in interactions that place the firm's interests ahead of 
investors' interests, or only permitting certain firm personnel to use 
the technology? Should the exclusion be time-limited, such as a 
limitation of 30, 60, or 90 days? Who would be eligible to be in the 
pilot group? Should investors be required to be notified, or to 
affirmatively consent before interactions with such investors are made 
part of such a pilot program? Would such a limitation create incentives 
not to test covered technologies thoroughly enough?
    31. Is the proposed requirement to test covered technologies prior 
to material modification sufficiently clear? For example, are there 
circumstances where it would not be apparent when a technology has been 
``materially modified'' for purposes of the proposed conflicts rules? 
We expressed our view that normal-course software updates, bug fixes, 
and security and other patches are not ``material modifications'' 
triggering retesting. Should we require testing of such updates, fixes, 
and patches? Should we modify the rule text to specify that such 
updates and patches are not material modifications? Should we provide 
additional guidance on what constitutes a material modification, such 
as basing it on ``major'' version numbers (e.g., 1.XXX, 2.XXX, 3.XXX, 
etc.) vs. ``minor'' version numbers (e.g., X.01, X.02, X.03, etc.)? 
Alternatively, are there situations where reference to version numbers 
would be inappropriate, such as when a material change for purposes of 
this rule would be assigned a minor version number? Should we make any 
special accommodation for technologies that are updated on a regular 
schedule, regardless of whether such modifications are material? Should 
firms be required to consider the cumulative impact of several 
modifications, each of which may not be material on its own, when 
considering whether a technology has been materially modified? If an 
algorithm itself has not been modified, but the data considered has 
been materially modified, should this be treated as a ``material 
modification'' for purposes of the proposed conflicts rules? If we were 
to do so, should we provide additional guidance on how firms should 
decide when a dataset has been materially modified?
    32. Is the proposed requirement to test covered technologies 
periodically sufficiently clear? Should firms be able to test different 
covered technologies on different timeframes depending on the specific 
risks of the covered technologies, as proposed? Should we require that 
covered technologies at least be tested on an annual basis or other 
specified frequency? Should we require some or all covered 
technologies, such as technologies whose outcomes may be difficult to 
explain or technologies that operate with limited human interaction, to 
be tested more frequently, such as every 30, 60, or 90 days?
    33. Should we specify any particular testing methodologies firms 
would be required to use, such as A/B testing? If we were to do so, 
should we only require such methodologies to be used on certain types 
of technologies and, if so, which ones? For example, should we require 
only PDA-like technologies (as opposed to all covered technologies) to 
be tested using certain methodologies such as A/B testing? Are there 
certain testing methodologies that are only applicable to certain types 
of technologies? Are there other methods firms may use to test 
compliance with the proposed conflicts rules, such as third-party 
consultants and, if so, should we explicitly address these other 
methods? For example, should we explicitly permit or require a firm to 
rely on an analysis prepared by a third party? If we were to explicitly 
address third-party analyses, are there particular situations we should 
address? For example, should we permit firms to rely on analyses by 
developers of covered technologies that are licensed to firms? What 
standards would be necessary in order for a firm to reasonably rely on 
a third-party analysis? For example, should a third-party analyst be 
required to demonstrate a particular level of expertise, possess a 
particular credential, certification, or license, or be independent 
from the developer of the technology or the firm relying on the 
analysis?
    34. Should we provide an exception from the testing requirement? 
For example, for urgent changes that are necessary to protect against 
immediate investor harm, for regulatory reasons, or to correct 
unexpected developments, such as major bugs, security issues, or 
conflicts of interest that had not previously been identified (or that 
developed between periodic testing intervals). Should we require firms 
to create or maintain any documentation in connection with relying on 
such an exception? Should reliance on such an exception be subject to 
any conditions, such as conducting testing as soon as practicable or 
only for a limited, specified period of time (for example, a few days, 
a week, or a month)?
    35. Should we provide a temporary exception from the testing 
requirement for technologies that are already in use by firms and, if 
so, when should that exception expire? If we were to provide a 
temporary exception for technologies that are already in use, should 
the temporary exception also apply to other aspects of the proposed 
conflicts rules, such as the identification and evaluation, 
determination, or elimination or neutralization prongs, the policies 
and procedures requirement, or the proposed recordkeeping amendments?
c. Conflict of Interest
    Under the proposed conflicts rules, a conflict of interest would 
exist when a firm uses a covered technology that takes into 
consideration an interest of the firm or its associated persons. The 
proposed conflicts rules would cover use of a covered technology by 
both a firm and associated persons of the firm

[[Page 53982]]

and would address technologies that take into account both interests of 
the firm and the interests of its associated persons.\158\ The proposed 
conflicts rules would define ``conflict of interest'' broadly and make 
clear that, if a covered technology considers any firm-favorable 
information in an investor interaction or information favorable to a 
firm's associated persons, the firm should evaluate the conflict and 
determine whether such consideration involves a conflict of interest 
that places the interest of the firm or its associated persons ahead of 
investors' interests and, if so, how to eliminate, or neutralize the 
effect of, that conflict of interest.
---------------------------------------------------------------------------

    \158\ See paragraph (a) of the proposed conflicts rules. As 
discussed previously, while the use of covered technology that takes 
into consideration an interest of the firm or an associated person 
could present a conflict of interest, the proposed conflicts rules 
would provide an exception for situations where the covered 
technology is used in investor interactions solely for purposes of 
meeting legal or regulatory obligations or providing clerical, 
ministerial, or general administrative support. See proposed 
conflicts rules at paragraph (a) and discussion supra section 
II.A.1.b.
---------------------------------------------------------------------------

    We recognize that the proposed conflicts rules--including the broad 
definition of conflict of interest--means that some conflicts will be 
identified that do not place the interests of the firm or its 
associated persons ahead of those of investors, and thus would not need 
to be eliminated or their effect neutralized. However, a covered 
technology may consider many factors (e.g., as part of an algorithm or 
data input). One factor among three under consideration by the 
technology may be highly likely to cause the technology to place the 
interests of the firm ahead of investors, and the effect of considering 
that factor may be readily apparent. On the other hand, one conflicted 
factor among thousands in the algorithm or data set upon which a 
technology is based may, or may not, cause the covered technology to 
produce a result that places the interests of the firm ahead of the 
interests of investors, and the effect of considering that factor may 
not be immediately apparent without testing (as discussed above). 
Without a broad definition and resulting evaluation, this 
differentiation among factors that do, and do not, result in investor 
interactions that place the firm's interests ahead of investors' 
interests may be impossible.
    There are many ways in which a use of covered technology in 
investor interactions can be associated with a conflict of interest. 
For example, when covered technology takes into account the profits or 
revenues of the firm, that would be a conflict of interest under the 
proposal regardless of whether the firm places its interests ahead of 
investors' interests. Revenue or profits can be taken into account 
directly, such as if a firm populates an asset allocation algorithm on 
its website to prioritize investments that it is trying to promote 
because it benefits the firm (e.g., by over-weighting funds that make 
revenue sharing payments or proprietary funds).\159\ Likewise, if a 
firm deploys a covered technology to interact with an investor, such as 
by displaying selected or ranked options for retirement accounts that 
takes into account the amount of revenue the firm would receive, the 
firm's use of the covered technology would involve a conflict of 
interest regardless of whether the firm places its interests ahead of 
investors' interests.
---------------------------------------------------------------------------

    \159\ A conflict could exist irrespective of whether investment 
in such funds is in the best interest of the investor.
---------------------------------------------------------------------------

    Revenue or profits to the firm can also be indirectly taken into 
consideration and trigger the proposed conflicts rules, such as through 
incentivizing increased trading activity or opening of options or 
margin accounts, if increased trading or opening of such accounts would 
cause the firm to experience higher profits, such as through increased 
commissions or revenue sharing from the wholesaler that executes the 
trade or through increased profits for the firm.\160\ For example, if a 
firm uses a neural network to provide investment advice or generate 
general investment ideas to populate an investment allocation tool, the 
network may be caused to ingest vast amounts of historical or real-time 
data, then repeatedly be optimized or trained to determine which 
outcome(s) to generate.\161\ If one of the pieces of data that the 
neural network considers is the effect on the firm's interests, such as 
the firm's profitability or revenue, it involves a conflict that should 
be examined to determine whether it could produce outcomes, including 
changing outcomes over time (e.g., through drift), that place the 
interest of the firm ahead of the interest of the investor.
---------------------------------------------------------------------------

    \160\ These conflicts are distinct from the limited exception 
for conflicts of interest associated with more generally attracting 
investors to open new accounts, discussed in section II.A.2.e, 
infra, because generally attracting new investors is essential to 
the business of any firm. On the other hand, incentivizing specific 
types of activity (such as margin or options trading privileges, as 
opposed to opening a general account, or investing in a particular 
type of investment, as opposed to just opening an account to invest) 
that is particularly profitable to a firm (and is not always in 
investors' interest), is intentionally addressed by the proposed 
conflicts rules.
    \161\ See, e.g., Alexey Dosovitskiy, Google Research, Optimizing 
Multiple Loss Functions with Loss-Conditional Training (Apr. 27, 
2020), https://ai.googleblog.com/2020/04/optimizing-multiple-loss-functions-with.html.
---------------------------------------------------------------------------

    The specific interest that is taken into account, and the degree to 
which it is weighted in the covered technology, would not affect the 
determination of whether a conflict of interest exists, as the presence 
of any firm interest in any degree, for the reasons discussed above, 
would constitute a conflict of interest. Such considerations would be 
relevant, however, when considering whether the conflict of interest 
places the interest of the firm ahead of those of investors and 
therefore whether it is necessary to eliminate, or neutralize the 
effect of, the conflict of interest, as discussed further below, and, 
if so, what steps could be taken to do so.\162\
---------------------------------------------------------------------------

    \162\ See infra section II.A.2.e.
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed definition of 
conflict of interest, including the following items:
    36. Do commenters agree that a firm would have a conflict of 
interest with an investor if the firm takes into consideration its 
profits and revenues in its investor interactions using covered 
technology? Why or why not? Are there additional circumstances that 
should trigger the rule if the firm takes these circumstances into 
account in its investor interactions, such as considering any factor 
which is not directly in the interest of the investor? Should we narrow 
the proposed definition and, if so, are there particular activities 
that should be excluded, such as when a technology considers a very 
large dataset where the firm has no reason to believe that the data 
considers the interests of the firm, like a technology trained on all 
books in the English language? Are there other datasets that should be 
excluded and, if so, how broad should a dataset be required to be in 
order to qualify for the exclusion? If we were to provide an exclusion, 
should we do so by excluding particular activities or types of datasets 
by name, or through a more principles-based approach?
    37. Is the description of when a conflict of interest exists 
sufficiently clear? Would firms be able to identify what would and 
would not be a conflict of interest for purposes of the rules? Advisers 
already have a fiduciary duty to eliminate, or at least to expose, all 
conflicts of interest which might incline them--consciously or 
unconsciously--to render advice that is not disinterested, and broker-
dealers already have a duty to identify and at a minimum disclose or 
eliminate all conflicts of interest associated with a recommendation 
and mitigate certain conflicts of interest under Reg BI. How

[[Page 53983]]

do firms currently identify conflicts of interest associated with their 
use of what the proposed conflicts rules would define as covered 
technologies in order to ensure that such use complies with existing 
standards? Will it be confusing to firms that the proposed conflicts 
rules also use the term ``conflict of interest'' to describe a 
distinct, but related, concept? If so, should we use a different term 
other than ``conflict of interest,'' such as a ``technology conflict'' 
or a ``potential conflict of interest?''
    38. The proposed definition of ``conflict of interest'' would also 
include interests of firms' associated persons. What challenges, if 
any, would firms face due to this aspect of the proposed conflicts 
rules? Should we make any changes as a result? For example, should we 
limit the scope of the definition to conflicts of interest of which the 
firm is aware or reasonably should be aware? Instead of or in addition 
to covering conflicts of interest that arise due to the interests of 
firms' associated persons, should we prescribe any additional 
requirements, such as additional diligence or policies and procedures, 
relating to conflicts of interest of firms' associated persons? In 
addition to natural persons, should we explicitly adopt a definition of 
``conflict of interest'' that would cover interests of entities 
controlling, controlled by, or under common control with firms, or 
other affiliates (or modify the rule provisions requiring the 
consideration of conflicts of associated persons to remove the 
limitations to associated persons that are natural persons)?
    39. If we were to provide an exclusion for technologies that 
consider large datasets where firms have no reason to believe the 
dataset favors the interests of the firm, should we require such 
datasets to meet minimum standards? For example, should we require 
firms to conduct diligence regarding how the data was collected in 
order to support their determination that the dataset does not 
incorporate the firm's interests? Should there be different standards 
for data that is itself generated in part by a technology that may meet 
the definition of covered technology (and thus may incorporate its own 
conflicts of interest), such as subjecting that technology to all or 
part of the proposed rules?
    40. Should we incorporate other minimum standards into data 
considered by covered technologies that are not directly related to 
interests of the firm but may implicate other Commission priorities, or 
have public policy implications? For example, should we require firms 
to take steps to understand whether the data does or could involve 
material nonpublic information? Should firms be required to consider 
whether the data is sensitive data that could be subject to 
cybersecurity or privacy rules?
    41. Do firms ever provide firm-favorable information to their 
covered technologies for the purpose of explicitly instructing the 
covered technology not to consider such information? Are there other 
circumstances in which covered technologies consider firm-favorable 
information that do not raise conflict of interest concerns? If so, 
should we make any changes to the definition of conflict of interest as 
a result? How could firms determine that no conflict of interest 
concerns are associated with their use of a covered technology without 
conducting the steps that would be required under the proposed 
conflicts rules?
    42. Is it clear that the proposed definition of conflict of 
interest includes when the covered technology has the potential to take 
into account the firm's (or its associated persons') interests, 
including the firm's revenue or profits, directly or indirectly? Are 
there steps we could take to clarify, for example by providing 
additional examples of factors that, if considered, would constitute a 
conflict of interest?
    43. Do commenters agree that, as proposed, a conflict of interest 
would exist even if a covered technology factors in a single firm- or 
associated person-favorable interest among many other factors that do 
not favor the firm or its associated person, regardless of which 
interest is favored and the degree to which it is weighted? Should the 
specific interest of the firm or associated person that is taken into 
account, such as the firm's revenues or profits, or the degree to which 
it is weighted in the covered technology, affect the determination of 
whether a conflict of interest exists at all? How would this differ in 
practice from determining that a conflict of interest does exist but 
does not place the firm's interests ahead of investors' interests?
    44. Should we exclude certain categories of conflicts?
d. Determination
    The proposed conflicts rules would require a firm, after evaluating 
any use or reasonably foreseeable potential use of a covered technology 
by a firm or its associated person in any investor interaction to 
identify any conflict of interest associated with that use or potential 
use, to determine whether such conflict of interest places or results 
in placing the firm's or its associated person's interest ahead of 
investors' interests, subject to certain exceptions.\163\ Determining 
whether an investor interaction involving such a conflict of interest 
would place or results in placing the firm's or its associated person's 
interests ahead of investors' interests is a facts and circumstances 
analysis, and would depend on a consideration of a variety of factors, 
such as the covered technology, its anticipated use, the conflicts of 
interest involved, the methodologies used and outcomes generated, and 
the interests of the investor. Based on this analysis, a firm must 
reasonably believe that the covered technology either does not place 
the interests of the firm or its associated persons ahead of investors' 
interests, or the firm would need to take additional steps to 
eliminate, or neutralize the effect of, the conflict.\164\ Applicable 
law already limits firms' use of technologies whose outputs are based 
in part on data points favorable to a firm in certain circumstances. 
Investment advisers using such technologies to provide investment 
advice are already required to consider whether they could cause the 
adviser ``consciously or unconsciously to render advice which is not 
disinterested.'' \165\ Similarly, broker-dealers that use technology to 
make certain recommendations to a retail customer must establish, 
maintain, and enforce written policies and procedures reasonably 
designed to achieve compliance with Reg BI, including its Conflict of 
Interest Obligation.\166\
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    \163\ Proposed conflicts rules at (b)(2).
    \164\ The proposed conflicts rules do not prescribe strict 
numerical weights. Instead, determination of the relative level of 
benefits to the firm and to the investor should take into account 
all applicable facts and circumstances.
    \165\ See Fiduciary Interpretation, supra note 8.
    \166\ See Exchange Act rule 15-1(a)(2)(iii) and (iv).
---------------------------------------------------------------------------

    In the case of many covered technologies, it may be readily 
apparent that, while the technology may take into account an interest 
of the firm, it does not result in the firm's interests being placed 
ahead of investors' interests. For example, many investment advisers 
create financial models of a portfolio company's three financial 
statements (i.e., the company's balance sheet, income statement, and 
statement of cashflows) to help evaluate whether to advise their 
clients to invest in a particular portfolio company. It is not uncommon 
for a financial model to show the potential returns of the investment 
for the client, along with a potential performance-based fee that would 
be received by the adviser, if the portfolio company achieved certain 
levels of growth. An adviser's consideration of metrics that are 
favorable to it, such as a potential

[[Page 53984]]

performance-based fee it could receive, would constitute a conflict of 
interest under the proposed conflicts rules. Under the determination 
requirement, however, the adviser could, based on the applicable facts 
and circumstances, determine that such conflict of interest does not 
result in its own interests being placed ahead of investors' interests 
if the outcome is equally (or more) favorable to the investor 
regardless of whether the factor is considered.\167\
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    \167\ Even though the proposed conflicts rules would not require 
the conflict of interest to be eliminated or its effect to be 
neutralized, this would remain a conflict of interest under the 
proposed conflicts rules (and under existing law). See Performance-
Based Investment Advisory Fees, Investment Advisers Act Release No. 
5904 (Nov. 4, 2021) [86 FR 62473 (Nov. 10, 2021)], at n.3 and 
accompanying text (noting the incentive ``to engage in speculative 
trading practices while managing client funds in order to realize or 
increase [contingent] advisory fees'' such as incentive 
allocations). An adviser would still be required to disclose the 
conflict with sufficient specificity that a client could provide 
informed consent. See Fiduciary Interpretation, supra note 8, at 
nn.67-70 and accompanying text.
---------------------------------------------------------------------------

    On the other hand, if the model is designed to screen out an 
investment if it would not result in a sufficient performance-based fee 
for the adviser despite acceptable returns for investors, this would be 
an example of the adviser's interests being placed ahead of investors' 
interests because the investors are being deprived of an investment due 
to the adviser's consideration of its own interest. Covered 
technologies like the model in this example, which explicitly and 
intentionally consider a firm's interests as an integral part of its 
outputs, are highly likely to result in investor interactions that 
place the interests of the firm ahead of investors' interests. Firms 
should consider carefully reviewing the outputs of such technologies to 
determine whether the firm's or its associated persons' interests are 
being placed ahead of the interests of the investor (e.g., by reviewing 
how the outputs vary if the firm's or associated persons' interests are 
not considered).
    Similarly, a broker-dealer may bring general investment ideas to 
the attention of retail investors, using an algorithm for selection, 
where some of the investments that may be selected provide revenue to 
the firm if the investor places an order to purchase. If the firm 
determines that in selecting the investment ideas, the algorithm used 
for selecting the investment ideas does not place the firm's interests 
ahead of investors' interests--because, for example, it does not give 
more prominence to the investments that provide revenue to the firm 
than those that do not and no one investment is being recommended--it 
could reasonably determine that the conflict of interest created by the 
algorithm considering the revenue does not require elimination or 
neutralization under the proposed conflicts rules.\168\
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    \168\ While the proposed conflicts rules may not require 
elimination or neutralization, to the extent a broker-dealer uses 
such technology to make a recommendation to a retail customer, other 
existing regulatory obligations, such as Reg BI and Form CRS, would 
apply. See supra section I.B.
---------------------------------------------------------------------------

    If, on the other hand, the firm determined that the algorithm was 
more likely to give greater prominence to those investments that are 
more profitable for the firm over other options of equal or better 
quality, then it could not reasonably determine that the conflict does 
not result in investor interactions that place its interests ahead of 
investors' interest and thus, would be required to eliminate, or 
neutralize the effect of, the conflict by the proposed conflicts rules. 
As another example, the covered technology a firm uses to decide when 
to communicate with investors may send an automatic message to 
investors encouraging them to ``hold steady'' during a period of high 
volatility in the market. If the technology is programmed to send out 
such a message during a period of high volatility but only after a 
certain threshold of fee-earning assets are withdrawn from the firm, 
the use of that technology would involve a conflict of interest because 
it would consider a proxy for the firm's revenues. However, if the 
primary purpose of the automatic message is to keep investors from 
over-reacting to short-term market moves, that could be beneficial for 
such investors. Even though the firm would be required to identify and 
evaluate the conflict of interest in order to comply with the proposed 
conflicts rules, the firm could reasonably determine that its interests 
were not placed ahead of investors' interests, and thus it did not need 
to eliminate, or neutralize the effect of, the conflict of interest.
    A firm generally should tailor the methods by which it determines 
whether its use of covered technologies in investor interactions places 
its interests ahead of investors based on the circumstances and the 
complexity of the underlying covered technology as well as the 
complexity of the conflict of interest. To the extent a firm has 
difficulty identifying whether a use of a covered technology in an 
investor interaction presents a conflict of interest within the meaning 
of the proposed conflicts rules, it also would have difficulty 
determining whether the technology could place the interests of the 
firm ahead of the interests of investors.\169\ In such circumstances, 
the firm may need to use additional tools to comply with the proposed 
determination requirement. For example, if a firm built 
``explainability'' functionality into the covered technology that gives 
the model the capacity to explain why it reached a particular outcome, 
recommendation, or prediction, this functionality could assist with the 
identification and determination elements of the proposed conflicts 
rules.\170\ A firm using explainability features could review the 
output to determine whether the firm's interests were being placed 
ahead of those of investors and, in any circumstance where it was not 
clear whether the firm's interests were being placed ahead of 
investors, the firm could comply with the proposed conflicts rules for 
example, by ceasing to use the technology or by prophylactically 
treating such an ambiguity as a conflict of interest that must be 
eliminated or its effect neutralized.\171\
---------------------------------------------------------------------------

    \169\ See supra note 151 and surrounding text (discussing 
building explainability features into ``black box'' algorithms). We 
believe that the ``should have identified'' standard in paragraph 
(b)(3) of the proposed conflicts rules addresses situations where a 
firm's determination that a conflict of interest does not place its 
interests ahead of investors' turns out to be unreasonable because 
it would still hold a firm accountable for the unreasonable 
determination. See infra section II.A.2.e.
    \170\ See id.
    \171\ See infra section II.A.2.e.
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    Even when explainability features are built into a covered 
technology, a firm might still be unable to determine whether the 
covered technology places its own interests ahead of investors' 
interests. If a firm cannot determine that its use of a covered 
technology in investor interactions does not result in a conflict of 
interest that places its interests ahead of those of investors, the 
firm generally should consider any conflict of interest associated with 
such use as one that must be eliminated or its effect neutralized, and 
take steps necessary to do so.\172\ For example, as

[[Page 53985]]

explained more fully in the following section, the firm could apply a 
``counterweight'' to a conflict (that is, it could give more weight to 
certain investor-favorable information in order to make up for the 
consideration of firm-favorable information) that would be sufficient 
to neutralize the effect of conflicts that the firm reasonably foresees 
could result from the use of the covered technology.\173\ We 
acknowledge determinations for covered technologies that consider a 
multitude of different data points may render it more challenging to 
isolate the effect of any particular data point on the outcome and, 
thus, to determine whether it causes a conflict of interest that places 
the interest of the firm ahead of investors. These cases, in 
particular, may benefit from the testing methods outlined above. For 
example, A/B testing may reveal that there is no difference in outcomes 
in cases where the covered technology includes or excludes certain data 
points or groups of data points.
---------------------------------------------------------------------------

    \172\ See infra section II.A.2.e (discussing the ``should have'' 
identified standard). Firms that are unable to determine whether 
their own interests are placed ahead of investors' for purposes of 
the proposed conflicts rules should consider whether full and fair 
disclosure to facilitate informed consent are feasible in such 
circumstances. See, e.g., infra note 316 and accompanying text 
(discussing informed consent in the context of highly complex 
algorithms). In such circumstances, when informed consent is 
impossible, existing law requires an investment adviser to mitigate 
the conflict, which could include steps similar to those we outline 
in the discussion of elimination and neutralization. Similarly, 
where a broker-dealer that makes a recommendation to a retail 
customer using covered technology cannot provide ``full and fair'' 
disclosure of a conflict of interest, the broker-dealer may need to 
take additional steps to mitigate or eliminate the conflict under 
the existing standard of conduct. See Reg BI Adopting Release, supra 
note 8, at section I and text accompanying nn.735-36 (``[B]roker-
dealers are most capable of identifying and addressing the conflicts 
that may affect the obligations of their associated persons with 
respect to the recommendations they make, and are therefore in the 
best position, to affirmatively reduce the potential effect of these 
conflicts of interest such that they do not taint the 
recommendation.'').
    \173\ This is due to the ``should have identified'' standard. 
See infra section II.A.2.e.
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed conflict rules' 
determination requirement, including the following items:
    45. Does the proposed conflicts rules' determination requirement 
complement, overlap with, or duplicate the existing regulatory 
framework for broker-dealers and investment advisers? If so, in what 
ways? Specifically, would firms' compliance with those other regulatory 
requirements contribute to compliance with the proposed conflicts 
rules, and vice versa?
    46. Is the proposed requirement that a firm determine whether any 
conflict of interest that it has identified places or results in 
placing its or its associated persons' interests ahead of investors' 
interests sufficiently clear? Is the requirement sufficiently general 
that it would continue to apply to future technologies with features we 
may not currently anticipate? If not, why not? Do commenters agree that 
a conflict of interest that places a firm's or its associated persons' 
interests ahead of investors' interests also results in placing its or 
its associated persons' interests ahead of investors' interests? If so, 
is the rule clearer by including both phrases or should the proposed 
requirement eliminate the phrase ``results in placing''?
    47. How do firms currently determine whether their use of 
technology in investor interactions results in a conflict of interest 
that places the interests of the firm ahead of investors' interests? 
Are there particular processes or strategies that should be required in 
the proposed determination requirement? For example, should we 
specifically require the use of ``explainability'' features when the 
relationship between the outputs of a model and the inputs may be 
unclear (and it thus may be difficult to identify whether the interests 
of the firm are being placed ahead of investors' interests)? Do firms 
use A/B testing to determine the effects of conflicts of interest? What 
other types of testing do firms use to determine the effects of 
conflicts of interest, if any?
    48. What challenges will firms face when determining whether 
conflicts of interest associated with ``black box'' technologies (where 
the outputs do not always make clear which inputs were relied on, and 
how those inputs were weighted), result in their interests being placed 
ahead of those of investors? How prevalent are these situations? How do 
firms using ``black box'' technologies to aid in making recommendations 
or providing advice determine whether they are complying with existing 
conflicts obligations under the investment adviser fiduciary standard 
and Reg BI, as applicable? If a firm is not able to determine whether 
its use of such a technology results in a conflict of interest that 
places its interests ahead of those of investors, what additional steps 
will a firm need to take in order to eliminate, or neutralize the 
effect of, such conflicts and be able to continue to use the covered 
technology?
    49. The determination requirement would also require firms to 
determine whether the interests of an associated person of a firm are 
placed ahead of investors' interest. What challenges, if any, would 
firms face due to this aspect of the proposed conflicts rules? Should 
we make any changes as a result? For example, should we limit the scope 
of the requirement to conflicts of interest of which the firm is aware 
or reasonably should be aware? Instead of or in addition to covering 
firms' associated persons' interests, should we prescribe any 
additional requirements, such as additional diligence or policies and 
procedures, relating to conflicts of interest associated with firms' 
associated persons? In addition to natural persons, should the 
determination requirement apply in the context of entities that 
control, are controlled by, or are under common control with firms?
    50. Should we expand the determination requirement to cover other 
situations that would not be a ``conflict of interest'' as defined 
under the proposed conflicts rules, but would implicate other Federal 
securities laws, or other laws? For example, should firms be required 
to identify and evaluate whether their covered technologies use or 
consider any information that could be material nonpublic information?
    51. Are there other methods firms may use to determine whether a 
conflict of interest results in placing the interest of the firm or an 
associated person of the firm ahead of the investor, such as third-
party consultants and, if so, should we explicitly address these other 
methods? For example, should we explicitly permit or require a firm to 
rely on an analysis prepared by a third party? If we were to explicitly 
address third-party analyses, are there particular situations we should 
address? For example, should we permit firms to rely on analysis by 
developers of covered technologies that are licensed to firms? What 
standards would be necessary in order for a firm to reasonably rely on 
a third-party analysis? For example, should a third-party analyst be 
required to demonstrate a particular level of expertise, possess a 
particular certification or license, or be independent from the 
developer of the technology or the firm relying on the analysis?
e. Elimination or Neutralization of Effect
    The proposed conflicts rules would require a firm to eliminate, or 
neutralize the effect of, any conflict of interest it determines 
results in an investor interaction that places the firm's (or its 
associated persons') interest ahead of the interests of its 
investors.\174\ Consideration of any firm interest would be sufficient 
for a conflict of interest to exist under the proposed conflicts rules, 
but the consideration of a firm's interest, on its own, would not 
necessarily require that the firm eliminate, or neutralize the effect 
of, the conflict of interest.\175\ After identifying that a conflict of 
interest exists, the firm would then determine whether the conflict of 
interest results in the interest of the firm or an associated person 
being placed ahead of investors' interests. Only where the firm makes 
(or reasonably should make) such a

[[Page 53986]]

determination would the firm be required to eliminate, or neutralize 
the effect of, the conflict of interest.\176\ The proposed conflicts 
rules would require the firm to eliminate, or neutralize the effect of, 
any such conflict promptly after the firm determines, or reasonably 
should have determined, the conflict placed the interests of the firm 
or associated person ahead of the interests of investors. This 
requirement is designed to require a firm to take steps that are in 
addition to, but not in conflict with, the standard of conduct that 
applies when it is providing advice or making recommendations, as 
discussed below.\177\
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    \174\ Proposed conflicts rules at (b)(3).
    \175\ See infra section II.A.2.d.
    \176\ For the avoidance of doubt, the discussion concerns 
consideration by a technology of the interests of a firm, including 
situations where the firm creates technology that considers the 
firm's or an associated person's interests. Firms of course will 
consider their own interests (such as whether the cost of the 
technology is worth the benefit) when determining whether to deploy 
a technology. Such consideration, on its own, would not be within 
the scope of the proposed conflicts rules.
    \177\ See infra section III.C.3. (describing the applicable 
standards of conduct).
---------------------------------------------------------------------------

    The test for whether a firm has successfully eliminated or 
neutralized the effect of a conflict of interest is whether the 
interaction no longer places the interests of the firm ahead of the 
interests of investors.\178\ Under the proposed conflicts rules, a firm 
could ``eliminate'' a conflict of interest, for example, by completely 
eliminating the practice (whether through changes to the algorithm, 
technology, or otherwise) that results in a conflict of interest or 
removing the firm's interest from the information considered by the 
covered technology. For example, a firm that determined covered 
technology used in investor interactions favored investments where its 
receipt of revenue sharing payments placed the firm's interests ahead 
of investors' interests could eliminate the conflict, among other 
methods, by ending revenue sharing arrangements or by ensuring that its 
covered technologies do not consider investments that pay it revenue 
sharing payments.
---------------------------------------------------------------------------

    \178\ For the avoidance of doubt, if a firm substitutes one 
firm-favorable factor with a different factor that is a proxy for 
the firm-favorable factor, the firm has not eliminated, or 
neutralized the effect of, the conflict.
---------------------------------------------------------------------------

    However, a firm does not have to eliminate such conflicts. A firm 
instead could ``neutralize the effect of'' a conflict of interest by 
taking steps to address the conflict. In this regard, whether through 
elimination or neutralization, the proposed conflicts rules would 
require that any conflicts of interest not place the firm's interest 
ahead of investors' interests. In a neutralization scenario, the 
covered technology could continue to use the data or algorithm that 
includes the firm's or associated person's interest as a factor, but 
the firm would be required to take steps to prevent it from biasing the 
output towards the interest of the firm or its associated persons. The 
measure of whether the effect of the conflict has been neutralized 
would be if the investor interaction does not place the firm's or 
associated person's interest ahead of the investor. We are including 
neutralization as an additional method of addressing conflicts of 
interest under the proposed conflicts rules because of the unique ways 
that technology can be modified or counterweighted to eliminate the 
harmful effects of a conflict, as well as the ways it can be tested to 
confirm the modification or counterweighting was successful.
    Neutralization, for example, also could include rendering the 
consideration of the firm-favorable information subordinate to 
investors' interests, and thus making the conflict harmless, either by 
applying a ``counterweight'' (such as considering additional investor-
favorable information that would not have otherwise have been 
considered in order to counteract consideration of a firm-favorable 
factor) or by changing how the information is analyzed or weighted such 
that the technology always holistically weights other factors as more 
important so that biased data cannot affect the outcome.
    The proposed conflicts rules do not prescribe a specific way in 
which a firm must eliminate, or neutralize the effect of, its conflicts 
of interest. For example, if a firm that is a robo-adviser determines 
that it uses covered technology to direct or steer investors to invest 
in funds the firm itself sponsors and advises when more suitable or 
less expensive options for the investor are available through the robo-
adviser, and thereby prioritizes the firm's own profit over investors' 
interests, the firm could eliminate this conflict of interest by 
removing any data that would allow the robo-adviser to determine which 
funds are sponsored or advised by the firm, thus eliminating any bias 
in favor of the firm's interest.\179\ The firm, alternatively, may 
choose to neutralize the effect of the conflict.\180\ For instance, the 
firm could neutralize the effect of the conflict of interest by 
sufficiently increasing the weights given to factors, such as cost to 
the investor or risk-adjusted returns (including, in each case, 
comparisons to funds sponsored or advised by other firms), to provide a 
counterweight that prevents any consideration of the firm's own 
interests from resulting in an investor interaction that places the 
firm's interests ahead of investors' interests. The proposed conflicts 
rules permit firms discretion on how to address the conflict--whether 
by eliminating it altogether or neutralizing its effect--after 
considering the applicable facts and circumstances, provided that the 
method used prevents the firm from placing its interests or an 
associated person's ahead of investors' interest.
---------------------------------------------------------------------------

    \179\ As discussed supra section II.A.1.b, this includes a 
discretionary adviser where the investor does not need to approve 
each trade; the investor interaction in this case would be in the 
form of engagement through directing trades in the investor's 
account.
    \180\ As discussed above, this is also consistent with an 
adviser's fiduciary duty. An adviser ``must, at all times, serve the 
best interest of its client and not subordinate its client's 
interest to its own'' and, unless neutralized, a conflict of 
interest would have the effect of subordinating a client's interest 
to that of the firm. See Fiduciary Interpretation, supra note 8. 
Similarly, under Reg BI, broker-dealers must mitigate (i.e., reduce) 
or eliminate conflicts of interest that would otherwise cause the 
broker-dealer or its associated person to make a recommendation that 
is not in the best interest of the retail customer. See Exchange Act 
rule 15l-1(a)(2)(iii); Reg BI Adopting Release, supra note 8, at 
section II.C.3.g (``Elimination of Certain Conflicts of Interest'').
---------------------------------------------------------------------------

    The proposed conflicts rules do not prescribe a particular manner 
by which a firm must eliminate, or neutralize the effect of, any 
conflict of interest because of the breadth and variations of firms' 
business models as well as their use of covered technology. Because of 
the complexity of many covered technologies, as well as the ways in 
which conflicts of interest may be associated with their use, we are 
concerned that prescribing particular means to neutralize the effect of 
a conflict of interest could be inapplicable or otherwise ineffective 
with respect to certain covered technologies (or certain conflicts of 
interest, the nature and extent of which may vary substantially across 
firms depending on their particular business models and investor 
base).\181\ The proposed approach is intended to promote flexibility 
and innovation by allowing the firms that use covered technologies the 
freedom to determine the appropriate ways to operate them, within the 
guardrails provided by the proposed conflicts rules, rather than 
requiring the technologies to be designed in a

[[Page 53987]]

particular way solely to meet a regulatory requirement.
---------------------------------------------------------------------------

    \181\ This same recognition of the complexity of many covered 
technologies is why disclosure alone could be insufficient to 
adequately address the conflicts of interest associated with their 
use. Cf. infra section III.D.1 (disclosure alone may not necessarily 
address negative outcomes when ``the issue lies in human 
psychological factors, rather than a lack of information.'').
---------------------------------------------------------------------------

    We recognize that reasonable steps a firm could take to eliminate, 
or neutralize the effect of, a conflict of interest that results in an 
investor interaction that places the firm's interest ahead of 
investors, are likely to vary and would depend on the nature of the 
conflict, the nature of the covered technology, the circumstances in 
which the covered technology is used, and the potential harm to 
investors. For example, if the firm's evaluation of the conflict 
indicates that the technology would only result in investor 
interactions that place the firm's or an associated person's interests 
ahead of investors' interests in certain limited circumstances, a firm 
could eliminate the conflict of interest by taking steps to prevent the 
technology from being used in such circumstances, or by choosing to 
eliminate the business practice that is associated with the conflict in 
the first place. Similarly, if a technology only involves a conflict of 
interest due to its consideration of certain data or the weights 
ascribed to certain data points, the firm could either prevent the 
technology from accessing such data (eliminating the conflict), or the 
firm could take steps to prevent its consideration of the data from 
having an effect on the outcome of the technology (neutralizing the 
effect of the conflict), either through consideration of additional, 
investor-favorable data designed to provide a countervailing signal to 
the technology, or through weighting the data the covered technology 
considers so that the firm- or associated person-favorable data would 
not be determinative to the outputs.\182\ A firm could also neutralize 
the effect of a conflict by requiring that firm personnel who are 
trained on the nature of the conflict of interest (e.g., personnel 
responsible for supervising the implementation of the firm's compliance 
program) operate the technology and only pass along information to 
investors after they deem, based on their training, that the 
information does not involve a conflict that results in an investor 
interaction that places the interests of the firm or an associated 
person ahead of investors' interests.\183\
---------------------------------------------------------------------------

    \182\ Whether the firm-favorable data is determinative of the 
technology's outputs could be verified through A/B testing. See 
supra section II.A.2.b. The specific data or weights that would be 
necessary to neutralize a particular conflict would depend on 
factors such as the conflict itself as well as the design of the 
applicable technology.
    \183\ This example assumes the investor interaction is indirect; 
we anticipate that firm personnel would not have the ability to 
intervene when a technology directly interacts with investors.
---------------------------------------------------------------------------

    The proposed conflicts rules would require a firm to eliminate, or 
neutralize the effect of, a conflict of interest that it determines 
results in an investor interaction that places its interests ahead of 
investors' interests ``promptly'' after the firm determines, or 
reasonably should have determined, that the conflict results in its own 
(or an associated person's) interests being placed ahead of investors' 
interests.\184\ Determining what constitutes ``promptly'' in any given 
situation under the proposed conflicts rules would depend on the facts 
and circumstances. If eliminating, or neutralizing, the effect of, the 
conflict is straightforward, as would be the case if a firm simply had 
to update the settings of an application or restrict access using tools 
it already possessed, elimination or neutralization could happen soon 
after the identification of the conflict of interest.
---------------------------------------------------------------------------

    \184\ If it is determined before technology is first deployed 
that a conflict of interest exists that places the firm's or an 
associated person's interests ahead of investors' interests, 
``prompt'' elimination or neutralization of the conflict could occur 
any time before the technology is initially deployed. That is, we do 
not believe it would be consistent with the proposed conflicts rules 
for a firm to initially deploy a technology that a firm has already 
determined (or should have determined) is subject to conflicts of 
interest that place the firm's or an associated person's interests 
ahead of its investors' interests, then eliminate, or neutralize the 
effect of, those conflicts after the fact.
---------------------------------------------------------------------------

    But if elimination, or neutralization of the effect of, a conflict 
of interest would require substantial amounts of new coding by firm 
personnel, we recognize that such modifications may take longer to 
implement, including because they may constitute material modifications 
that would need to be tested to determine whether any modifications 
eliminated, or neutralized the effect of, the conflict as expected, as 
well as to consider any new conflicts of interest that the 
modifications could cause. Though we recognize that modifications would 
not happen immediately in all circumstances, an extended period of 
implementation may raise questions about whether the firm acted 
promptly and may raise questions as to whether they are acting in 
accordance with their standard of care. If a firm has determined that 
it needs additional time to eliminate, or neutralize the effect of, a 
conflict of interest in accordance with the proposed conflicts rules, 
it would also need to consider whether continuing to use such covered 
technology before the conflict is eliminated or neutralized would 
violate any applicable standard of conduct (e.g., fiduciary duty for 
investment advisers or Reg BI for broker-dealers). In certain cases, it 
may be impossible to comply with the applicable standard of conduct 
without stopping use of the covered technology before the conflict of 
interest can be adequately addressed. As it develops a schedule for 
eliminating, or neutralizing the effect of, the conflict, a firm should 
consider the nature of the covered technology, including how it is 
being used in investor interactions, and the complexity of any 
elimination or neutralization measures. The firm should also consider 
and seek to minimize potential risks posed to investors as a result of 
the continued use of the covered technology. This might include 
implementing heightened review of investor interactions to help ensure 
that the harm is relatively limited and weighing the risks of continued 
exposure to the conflict of interest during remediation against the 
risk of making the covered technology unavailable during remediation. 
If a firm has a reasonable basis to believe that pulling a covered 
technology out of service due to a conflict of interest would be a 
greater risk to investors than the conflict itself, a firm generally 
should consider closely surveilling and monitoring the investor 
interactions associated with its continued use of the technology to 
evaluate whether its expectation is accurate, or whether it should 
cease using the covered technology.
    The requirement for a firm to eliminate, or neutralize the effect 
of, conflicts of interest that place the firm's or an associated 
person's interest ahead of investors' interests covers such conflicts 
the firm identifies, as well as those it reasonably should have 
identified. That is, in order to comply with the proposed conflicts 
rules, a firm would be required to use reasonable care to determine 
whether these conflicts could arise as a result of its use of covered 
technologies and how they could affect investor interactions, and to 
address such conflicts rather than assuming that its covered 
technologies do not result in its own (or its associated persons') 
interests being placed ahead of investors' interests. The ``reasonably 
should have identified'' standard is designed to require firms to 
understand the covered technology they are deploying sufficiently well 
to consider all the material features of the technology both when 
evaluating the technology and identifying conflicts, and later when 
determining whether those conflicts place their own (or their 
associated persons') interests ahead of investors' interests.
    Because firms' use of covered technology is likely to be 
continuously changing, firms generally should consider how they will 
proactively

[[Page 53988]]

address reasonably foreseeable uses (which would include potential 
misuses) of the covered technology. Firms should identify future and 
evolving conflicts when evaluating their potential use of covered 
technology to make sure that they have eliminated, or neutralized the 
effect of, all conflicts they should have determined place their 
interests ahead of investors' interests, including as their use of 
technology evolves. One way to address potential misuses of a 
technology could be to limit access to particular technology to 
personnel who have been trained on the technology and how to use it in 
compliance with the proposed conflicts rules. This could prevent the 
technology from being used in investor interactions that place the 
firm's interests ahead of investors' interests.
    The proposed requirement is also designed to be consistent with a 
firm's applicable standard of conduct. Investment advisers, as 
fiduciaries, are prohibited from subordinating their clients' interests 
to their own (i.e., they may not place their interests ahead of their 
clients' interests).\185\ In addition, investment advisers must 
eliminate or at least expose through full and fair disclosure all 
conflicts of interest which might incline an investment adviser--
consciously or unconsciously--to render advice which was not 
disinterested.\186\ Where an adviser uses covered technology in an 
investor interaction, compliance with the proposed conflicts rules' 
requirement that conflicts of interest be eliminated or their effect 
neutralized could also help the adviser satisfy its fiduciary duty. 
Likewise, in satisfying its fiduciary duty, an adviser may also satisfy 
the proposed conflicts rules' requirement to eliminate, or neutralize 
the effect of, certain conflicts of interest. However, due to our 
concerns that scalability could rapidly exacerbate the magnitude and 
potential effect of conflicts,\187\ an adviser would not satisfy the 
proposed conflicts rules' requirement to eliminate, or neutralize the 
effect of, certain conflicts solely by providing disclosure to 
investors. As the Commission has previously stated, in cases where an 
investment adviser cannot fully and fairly disclose a conflict of 
interest to a client such that the client can provide informed consent, 
the adviser must take other steps such that full and fair disclosure 
and informed consent to the adviser's other business practices are 
possible.\188\ Moreover, as the Commission has previously stated, 
investment advisers must act in the best interests of their clients at 
all times and must not subordinate their clients' interests to their 
own.\189\ The standard in the proposed conflicts rules is thus 
consistent with that over-arching fiduciary obligation.
---------------------------------------------------------------------------

    \185\ See Fiduciary Interpretation, supra note 8, at section II.
    \186\ See Fiduciary Interpretation, supra note 8, at n.57 and 
accompanying text.
    \187\ See supra section I.A. for a discussion about scalability 
concerns.
    \188\ See Fiduciary Interpretation, supra note 8, at text 
following n.67.
    \189\ See generally id.
---------------------------------------------------------------------------

    Similarly, when making recommendations, broker-dealers must act in 
the best interest of a retail customer at the time the recommendation 
is made, without placing the firm's financial or other interest ahead 
of the retail customer's interests. This would include, under Reg BI's 
Conflict of Interest Obligation, a requirement to establish, maintain, 
and enforce written policies and procedures reasonably designed to, 
among other things, identify and at a minimum disclose, or eliminate, 
all conflicts of interest associated with a recommendation; identify 
and mitigate (i.e., modify practices to reduce) conflicts of interest 
at the associated person level; prevent any limitations placed on the 
securities or investment strategies involving securities that may be 
recommended to a retail customer and associated conflicts of interest 
from causing the broker-dealer, or a natural person who is an 
associated person of the broker-dealer, to make recommendations that 
place the interest of the broker-dealer or such natural person ahead of 
the interest of the retail customer; and eliminate sales contests, 
sales quotas, bonuses, and non-cash compensation that are based on the 
sales of specific securities or specific types of securities within a 
limited period of time.\190\ Accordingly, where a broker-dealer uses 
covered technology to make a recommendation, compliance with the 
proposed conflicts rules' requirement that conflicts of interest be 
eliminated or their effect neutralized could also help a broker-dealer 
comply with similar aspects of Reg BI's Conflict of Interest 
Obligation.
---------------------------------------------------------------------------

    \190\ See Exchange Act rule 151-1(a)(2)(iii).
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    For example, if a broker-dealer uses covered technology to make a 
recommendation to a retail customer, and the broker-dealer eliminates, 
or neutralizes the effect of, any firm- and associated person-level 
conflicts of interest under the proposed conflicts rule, it could help 
address compliance with certain aspects of Reg BI's Conflict of 
Interest Obligation. Conversely, compliance with Reg BI's Conflict of 
Interest Obligation could help a broker-dealer comply with the proposed 
conflicts rules' requirement to eliminate, or neutralize the effect of, 
certain conflicts of interest. However, because the proposed conflicts 
rules apply more broadly to the use of covered technology in investor 
interactions as noted earlier,\191\ and not just to recommendations, 
broker-dealers would be subject to both the proposed conflicts rules' 
requirements and, separately when making a recommendation, Reg BI, 
depending on the facts and circumstances of the investor interaction 
and the use of the covered technology.\192\
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    \191\ See supra note 80.
    \192\ Moreover, while compliance with the proposed rule's 
requirements could help address compliance with Reg BI's Conflict of 
Interest Obligation, a broker-dealer that makes a recommendation to 
retail customers would still be subject to Reg BI's other component 
obligations.
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    Depending on the facts and circumstances, the proposed requirement 
may apply in addition to existing requirements for addressing conflicts 
of interest. While existing requirements often address conflicts of 
interest through disclosure, certain obligations require more than 
disclosure to adequately address conflicts. For instance, under both 
the fiduciary standard and Reg BI, disclosure of conflicts alone does 
not necessarily satisfy the applicable standard of conduct. As noted 
above, under these standards, certain conflicts should (and in some 
cases, must) be addressed through elimination or mitigation.\193\ 
Similarly, when a firm uses covered technology in an investor 
interaction involving a conflict of interest, scalability can make 
disclosure of the conflict unachievable in many circumstances such that 
disclosure alone would be insufficient to adequately address the 
conflicts of interest. This is because a conflict can replicate to a 
much greater magnitude and at a much greater speed than would be 
possible to address through timely disclosure.
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    \193\ See, e.g., Fiduciary Interpretation, supra note 8, at 
nn.67-70 (discussing informed consent); Reg BI Adopting Release, 
supra note 8, at text accompanying nn.17-19 (discussing the Conflict 
of Interest Obligation's requirement for broker-dealers to identify 
and disclose, eliminate or mitigate conflicts associated with 
recommendations to retail customers).
---------------------------------------------------------------------------

    We recognize that many investor interactions could have the sole 
goal of encouraging investors to open a new account, and that firms may 
use covered technologies for this purpose. The proposed conflicts rules 
would not require conflicts of interest that exist

[[Page 53989]]

solely due to a firm seeking to open a new investor account to be 
eliminated or their effect neutralized. Even though opening an account 
would likely be in the interest of the firm, the proposed conflicts 
rules are not designed to limit firms' abilities to attract clients and 
customers. However, as noted above, incentivizing specific types of 
activity (such as margin or options trading privileges, as opposed to 
opening a general account, or investing in a particular type of 
investment, as opposed to just opening an account to invest) that is 
particularly profitable to a firm (and is not always in investors' 
interest), is intentionally addressed by the proposed conflicts rules.
    We request comment on all aspects of the proposed conflicts rules' 
elimination or neutralization requirement, including the following 
items:
    52. Considering that the proposed conflicts rules' elimination or 
neutralization evaluation requirement may overlap with existing 
regulatory requirements for broker-dealers and investment advisers, 
would firms' compliance with those other regulatory requirements 
contribute to compliance with the proposed conflicts rules, and vice 
versa? If so, in what ways?
    53. Are our concerns correct that scalability could rapidly 
exacerbate the magnitude and potential effect of the conflict in a way 
that could make full and fair disclosure and informed consent 
unachievable? Are there some conflicts that are more appropriately 
addressed by disclosure than others? Does this depend on the kind of 
investor interaction or kind of technology? For example, is scalability 
more problematic when an investor directly uses a covered technology 
than when an associated person communicates recommendations or advice 
that the associated person has generated using covered technology?
    54. The elimination or neutralization requirement would also 
require firms to eliminate, or neutralize the effect of, conflicts of 
interest associated with use or potential use of a covered technology 
by an associated person of a firm. What challenges, if any, would firms 
face due to this aspect of the proposed conflicts rules? Should we make 
any changes as a result? Instead of or in addition to covering 
conflicts of interest associated with associated persons' use of 
covered technologies, should we prescribe any additional requirements, 
such as additional diligence or policies and procedures, relating to 
conflicts of interest associated with associated persons? In addition 
to natural persons, should the elimination or neutralization 
requirement apply in the context of entities controlling, controlled 
by, or under common control with firms?
    55. Should firms be required to eliminate, or neutralize the effect 
of, conflicts of interest that place the firm's interests ahead of 
investors' interests as required under the proposed rules? Instead, 
should the elimination or neutralization obligation (or the 
requirements of sections (b)(1) or (b)(2) of the proposed conflicts 
rules) be limited to investor interactions involving, as applicable, 
investment advice or recommendations by a firm or its associated 
persons (or by a covered technology employed by a firm or its 
associated persons)? Should that obligation or requirements be limited 
to investor interactions directly with covered technologies? What other 
ways could we address the risks that conflicts of interest associated 
with firms' use of covered technologies will result in investor 
interactions that place the firm's interest ahead of the investor 
interest?
    56. Is the requirement to eliminate, or neutralize the effect of, 
certain conflicts of interest sufficiently clear? Should we provide any 
additional guidance on what we mean by ``neutralize the effect of''? If 
so, how? Instead of, or in addition to, elimination and neutralization, 
should the proposed conflicts rules require mitigation of some or all 
of the effects of conflicts of interest determined to place a firm's 
interests ahead of investors' interests under section (b)(2) of the 
proposed conflicts rules? If so, which conflicts? Is there additional 
guidance we should provide, or changes we should make to the text of 
the proposed conflicts rules, to clarify the distinction between 
elimination or neutralization, on the one hand, and mitigation, on the 
other hand?
    57. Are there particular methods that firms currently use to 
eliminate, or neutralize the effect of, conflicts of interest in 
investor interactions using covered technology? Should we indicate that 
certain methods (including limiting access to the technology, providing 
policies and procedures for ``safe'' use of the technology, limiting 
the data the technology considers, providing ``counterweights,'' or 
training the algorithm to ignore certain information) are methods we 
believe are generally appropriate to eliminate, or neutralize the 
effect of, conflicts of interest under the proposed conflicts rules or 
that certain methods are not appropriate for compliance with the 
proposed conflicts rules? If we were to provide additional guidance, 
how should we ensure that the proposed conflicts rules' requirement to 
eliminate, or neutralize the effect of, conflicts is sufficiently 
general that it would continue to apply to future technologies or 
future conflicts we may not currently anticipate as such technologies 
develop? Is using a ``counter-signal'' to train a learning model a 
useful way to eliminate, or neutralize the effect of, conflicts 
associated with the model? In addition to the testing requirement in 
section (b)(1) of the proposed conflicts rules, should we also require 
that firms that are eliminating, or neutralizing the effect of, 
conflicts of interest test the covered technology after such 
elimination or neutralization to determine whether it was successful?
    58. Is our understanding correct that the proposed conflicts rules, 
including the proposed elimination or neutralization requirement, are 
consistent with the applicable standards of conduct? To what extent 
will firms be able to utilize existing methods of addressing conflicts 
of interest and existing policies and procedures in order to comply 
with the proposed conflicts rules? For example, do firms expect to 
utilize their existing methods of addressing conflicts of interest 
under Reg BI or the fiduciary standard, as applicable, in order to 
comply with the proposed conflicts rules?
    59. The proposed investment adviser conflict prohibition would only 
apply to investment advisers registered or required to be registered 
under section 203 of the Advisers Act, meaning certain firms, including 
exempt reporting advisers and state-registered advisers, would not be 
covered. Should the prohibition be expanded to cover these entities? If 
the investment adviser conflict prohibition is widened to capture these 
entities, should the policies and procedures requirement in paragraph 
(c) of the proposed conflicts rules be similarly widened? Would certain 
types of advisers, such as those that primarily provide advice through 
an interactive website, be disproportionately affected by this 
proposal? Would any such advisers seek to restructure their operations 
to avoid this result? We are separately proposing updates to the 
internet adviser exemption, 17 CFR 275.203A-2. Should we modify any 
aspect of the proposed conflicts rules in order to coordinate with the 
proposed updates to the internet adviser exemption? \194\
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    \194\ See Exemption for Certain Investment Advisers Operating 
Through the internet, Investment Advisers Act Release No. 6354 (July 
26, 2023).
---------------------------------------------------------------------------

    60. How do firms currently ensure their use of what the proposal 
would define as covered technologies complies

[[Page 53990]]

with applicable existing rules and regulations or other legal 
obligations, including standards of conduct? Do firms using ``black 
box'' algorithms currently rely on disclosure instead of or in addition 
to affirmative design steps to address the actual and potential 
conflicts of interest associated with such algorithms? If so, what 
disclosure do firms provide and what form of informed consent do 
investors provide regarding firms' use of such algorithms? How do firms 
comply with the applicable standard of conduct, including the duty to 
act in the investor's best interest, particularly where they have been 
unable to determine whether their interests are being placed ahead of 
their investors?
    61. Is the exclusion for the use of covered technologies in 
investor interactions that have the sole goal of encouraging investors 
to open a new account sufficiently clear? Should this exclusion be 
narrowed or broadened, and, if so, how? For example, should we provide 
that the exclusion is only available if a firm does not differentially 
market to investors in order to guide them to open a particular type of 
account that is especially profitable for the firm, such as an options 
or margin account?
3. Policies and Procedures Requirement
    The proposed investment adviser conflicts rule would require every 
investment adviser that is subject to paragraph (b) of the rule and 
uses covered technology in any investor interaction to adopt and 
implement written policies and procedures reasonably designed to 
prevent violations of paragraph (b) of that rule.\195\ Likewise, the 
proposed broker-dealer conflicts rule would require every broker-dealer 
that is subject to paragraph (b) of that rule and that uses covered 
technology in any investor interaction to adopt, implement, and 
maintain written policies and procedures reasonably designed to achieve 
compliance with paragraph (b) of that rule.\196\ For all firms, these 
policies and procedures would need to include: (i) a written 
description of the process for evaluating any use or reasonably 
foreseeable potential use of a covered technology in any investor 
interaction pursuant to paragraph (b)(1) of the proposed conflicts 
rules and a written description of any material features of, including 
any conflicts of interest associated with the use of, any covered 
technology used in any investor interaction prior to such covered 
technology's implementation or material modification, which must be 
updated periodically; \197\ (ii) a written description of the process 
for determining whether any conflict of interest identified pursuant to 
paragraph (b)(1) of the proposed conflicts rules results in an investor 
interaction that places the interest of the firm or its associated 
persons ahead of the interests of the investor; \198\ (iii) a written 
description of the process for determining how to eliminate, or 
neutralize the effect of, any conflicts of interest determined pursuant 
to paragraph (b)(2) of the proposed conflicts rules to result in the 
interest of the investment adviser, broker-dealer, or the firm's 
associated persons being placed ahead of the interests of the investor; 
\199\ and (iv) a review and written documentation of that review, no 
less frequently than annually, of the adequacy of the policies and 
procedures and written descriptions established pursuant to this 
policies and procedures requirement and the effectiveness of their 
implementation. Although it is possible that some firms that use 
covered technology in investor interactions may not identify any 
conflicts of interest in carrying out the requirements of paragraph 
(b)(1) of the proposed conflicts rules, such firms would still be 
required to adopt, implement, and, in the case of broker-dealers, 
maintain these written policies and procedures, so as to be prepared to 
address any instance where such a conflict of interest is later 
identified by the firm in the course of its ongoing operations.
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    \195\ See proposed rule 211(h)(2)-4(c)(3). See also discussion 
of proposed conflicts rules at paragraphs (b)(1) through (3) supra 
section II.A.2. As noted above, the definition of ``investor 
interaction'' ``does not apply to interactions solely for purposes 
of meeting legal or regulatory obligations or providing clerical, 
ministerial, or general administrative support.'' See proposed 
conflicts rules at paragraph (a) and discussion supra section 
II.A.1.b.
    \196\ See proposed rule 15l-2(c). Under the Commission's rules, 
investment advisers historically have been required to ``adopt and 
implement'' policies and procedures that are ``reasonably designed 
to prevent violation'' of the Advisers Act or rules adopted 
thereunder, while broker-dealers have been required to ``establish, 
maintain, and enforce'' policies and procedures that are 
``reasonably designed to achieve compliance with'' the particular 
rule. Compare 17 CFR 206(4)-7(a) (investment advisers required to 
``adopt and implement written policies and procedures reasonably 
designed to prevent violation'') with 17 CFR 240.15l-1(a)(2)(iv) 
(broker dealers required to ``establish[ ], maintain[ ], and 
enforce[ ] written policies and procedures reasonably designed to 
achieve compliance with''). In order to assist firms with compliance 
with the proposed conflicts rules' policies and procedures 
requirements, we have used language that is consistent with these 
respective rules. Accordingly, the wording of the proposed policies 
and procedures requirements varies between investment advisers and 
broker-dealers. We do not believe, however, that there is a 
substantive difference between how firms would need to comply with 
each proposed rule. See, e.g., Reg BI Adopting Release, supra note 
8, at text accompanying n.810 (discussing policies and procedures 
requirements for investment advisers and broker-dealers without 
noting any difference despite the differing language).
    \197\ Proposed conflicts rules at (c)(1).
    \198\ Proposed conflicts rules at (c)(2).
    \199\ Proposed conflicts rules at (c)(3).
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    These proposed policies and procedures requirements are designed to 
help ensure that a firm understands how its covered technologies work 
when engaging in any investor interaction using covered technologies, 
the conflicts of interest those covered technologies present, and the 
potential effects of those conflicts on investors.\200\ Further, these 
proposed requirements are designed to help ensure that firms will not 
place their own interests ahead of the interests of investors where 
such conflicts of interest are associated with the firm's use of 
covered technology. A firm's failure to adopt and implement (and, in 
the case of broker-dealers, maintain) these policies and procedures 
would constitute a violation of the proposed conflicts rules 
independent of any other securities law violation. As a result, the 
proposed conflicts rules would address the failure of a firm to 
adequately describe how a covered technology works and the actual or 
potential conflicts the technology's use could create with the 
interests of investors before any such conflicts cause actual harm to 
investors.
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    \200\ The policies and procedures requirements complement the 
elimination and neutralization requirement, and are intended to 
encourage development of risk-based best practices by firms, rather 
than to impose a one-size-fits-all solution. Cf. Chamber of Commerce 
AI Report, supra note 144, at 89 (discussing necessity of firms 
deploying certain technologies ``having sufficient understanding of 
the system to provide effective human oversight'').
---------------------------------------------------------------------------

    We are proposing minimum standards for the written descriptions and 
annual review that a firm's policies and procedures would need to 
include. However, the proposed conflicts rules would provide firms with 
flexibility to determine the specific means by which they address each 
element, and the degree of prescriptiveness the firm includes in their 
policies and procedures. To satisfy the proposed conflicts rules' 
requirement to have policies and procedures including the specified 
written descriptions and annual review, firms generally should take 
into consideration the nature of their operations, and account for the 
covered technologies in use or to be used. Further, in satisfying the 
proposed conflicts rules, a firm should account for any use or 
reasonably foreseeable potential use of a covered technology that does 
or could result in conflicts of

[[Page 53991]]

interest in light of the firm's particular operations. For example, 
under the proposed conflicts rules, the level of detail firms would 
need to include when producing a written description of any material 
features of any covered technology used in any investor interaction, 
and the conflicts of interest associated with the use of that 
technology, will generally be less for those firms that either engage 
in a very limited use of covered technology, or that only use covered 
technologies that are relatively simple.
    On the other hand, for a firm that makes extensive use of more 
complex covered technology, such as machine learning technologies that 
function automatically without direct interaction with firm personnel, 
or a firm whose conflicts of interest are more complex or extensive, 
the policies and procedures would need to be substantially more robust. 
This could include consideration of all aspects of the covered 
technologies the firm uses, including the data used to train the 
technologies, ``explainability'' requirements, specific training for 
technical staff, and maintaining (and regularly reviewing) logs 
sufficient to identify any risks the firm's use of a covered technology 
presents of non-compliance with the proposed conflicts rules.
    In addition to the requirements outlined in paragraphs (c)(1)-(4) 
of the proposed conflicts rules, firms designing policies and 
procedures reasonably designed to achieve compliance with paragraph (b) 
of the proposed conflicts rules generally should consider including 
other elements, as appropriate, such as: (i) compliance review and 
monitoring systems and controls; (ii) procedures that clearly designate 
responsibility to appropriate personnel for supervision of functions 
and persons; (iii) processes to escalate identified instances of 
noncompliance to appropriate personnel for remediation; and (iv) 
training of relevant personnel on the policies and procedures, as well 
as the forms of covered technology used by the firm.
    We request comment on all aspects of the scope of the proposed 
conflicts rules' policies and procedures requirement, including the 
following items:
    62. Does the proposed conflicts rules' policies and procedures 
requirement complement, overlap with, or duplicate the existing 
regulatory framework for broker-dealers and investment advisers? If so, 
in what ways? Specifically, would firms' compliance with those other 
regulatory requirements contribute to compliance with the proposed 
conflicts rules, and vice versa?
    63. Are all aspects of these proposed policies and procedures 
requirements, as well as the particular written descriptions and review 
to be required by a firm's policies and procedures, necessary and 
appropriate for achieving compliance with paragraph (b) of the proposed 
conflicts rules? If not, what elements should be added, deleted, or 
modified to better ensure firms' compliance with paragraph (b) of the 
proposed conflicts rules?
    64. Several aspects of the proposed conflicts rules address 
conflicts of interest associated with use or potential use of a covered 
technology by an associated person of a firm; should any aspect of the 
proposed policies and procedures requirement be changed as a result? 
For example, instead of, or in addition to, maintaining an explicit 
reference to a firm's associated persons in paragraph (b) of the 
proposed conflicts rules, should we prescribe any additional 
requirements, such as additional diligence or policies and procedures, 
relating to conflicts of interest of firms' associated persons?
    65. Is the scope of firms covered by the proposed policies and 
procedures requirement appropriate in light of the requirements of 
paragraph (b) of this proposed rule? Should the proposed rule be 
modified to only require these policies and procedures of those firms 
that have identified at least one conflict of interest in their 
evaluation of any covered technology that is used or that it is 
reasonably foreseeable that the firm could potentially use in any 
investor interaction?
    66. Should the proposed rule require that senior firm personnel 
and/or specific technology subject-matter experts participate in the 
process of adopting and implementing these policies and procedures? If 
so, which parties, and what should be their required scope of 
responsibilities? Further, should any senior firm personnel and/or 
specific technology subject-matter experts be required to certify that 
such policies and procedures that the firm adopts and implements are in 
compliance with the requirements of this paragraph (c) of the proposed 
conflicts rules? Would there be costs associated with such 
participation or certification? If so, what are they? When designing 
their policies and procedures, should firms be required to include some 
or all of the following: (i) compliance review and monitoring systems 
and controls; (ii) procedures that clearly designate responsibility to 
appropriate personnel for supervision of functions and persons; (iii) 
processes to escalate identified instances of noncompliance to 
appropriate personnel for remediation; and (iv) training of relevant 
personnel on the policies and procedures, as well as the forms of 
covered technology used by the firm?
a. Written Description of Evaluation Process To Identify Conflicts of 
Interest and Written Description of Material Features
    Under the proposed policies and procedures requirement, firms would 
need to adopt and implement (and, in the case of broker-dealers, 
maintain) written policies and procedures reasonably designed to 
achieve compliance with paragraph (b) that include a written 
description of the process for evaluating any use or reasonably 
foreseeable potential use of a covered technology in any investor 
interaction pursuant to paragraph (b)(1), and a written description of 
the material features of, including any conflicts of interest 
associated with the use of, any covered technology used in any investor 
interaction.\201\
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    \201\ Proposed conflicts rules at (c)(1).
---------------------------------------------------------------------------

    The proposed requirement to include a written description of the 
process for evaluating any use or reasonably foreseeable potential use 
of a covered technology in any investor interaction within the firm's 
written policies and procedures is designed to help ensure the firms 
establish and follow a defined process for evaluating any use or 
reasonably foreseeable potential use of a covered technology in any 
investor interaction and consequently identifying any conflict of 
interest associated with that use or potential use, as required by 
paragraph (b)(1). Although the scope of any individual evaluation may 
depend on a variety of factors, including the specific covered 
technology in question, the manner in which that covered technology 
would interact with investors, and how the technology may be used, this 
process generally should be designed to provide firms with a consistent 
approach to satisfying the requirements of paragraph (b)(1) of the 
proposed conflicts rules. This written description would assist firms 
in performing the vital initial step of identifying all relevant 
conflicts of interest, which is necessary to ultimately complying with 
the proposed conflicts rules' requirement to eliminate, or neutralize 
the effect of, those conflicts of interest that place or result in 
placing the interest of the firm or its associated persons ahead of the 
interests of the investor. In addition to assisting the firm's internal 
staff, this

[[Page 53992]]

written description of the process that firms will use would assist the 
Commission's examinations staff in assessing the firm's compliance with 
the entirety of the proposed conflicts rules.
    This written description must articulate a process for the firm to 
use in evaluating any use or reasonably foreseeable potential use of a 
covered technology by the firm or its associated persons in any 
investor interaction to identify any conflict of interest associated 
with that use or potential use. Further, this process must address how 
the firm will conduct the required testing of each such covered 
technology prior to its implementation or material modification, and 
periodically thereafter, to determine whether the use of such covered 
technology is associated with a conflict of interest. Although we 
recognize that this process must be flexible enough to account for 
different types of covered technologies and investor interactions that 
those technologies might be used in, the firm's written description 
generally should be specific enough to ensure the consistent 
identification of any associated conflicts of interest. The process 
described by the firm generally should detail those steps it will take 
in conducting this evaluation, as well as the means it will use in 
identifying each relevant conflict of interest.
    To further promote compliance with the evaluation and 
identification required under paragraph (b)(1), a firm's policies and 
procedures would be required to include a written description of the 
material features of any covered technology used in any investor 
interaction, including any conflicts of interest associated with the 
use of the covered technology, and would need to be prepared prior to 
its implementation or material modification, and updated periodically. 
As discussed above, we are concerned that some firms currently lack a 
holistic understanding of the covered technologies they employ, and 
that this could result in investor interactions that are based on 
unknown conflicts of interest that are harmful to the investor.\202\ 
These concerns are heightened when firm personnel who are responsible 
for ensuring the covered technology complies with applicable laws and 
regulations, including SRO rules, do not fully understand how the 
covered technology would work in interactions with investors, and, 
thus, the risks the covered technology might present to those 
investors.
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    \202\ See supra section I.B (background discussion on conflicts 
of interest).
---------------------------------------------------------------------------

    The proposed written description element is designed to address 
these risks in a manner that helps ensure that the firm has identified 
and developed an understanding of those conflicts of interest that 
might impact the firm's investor interactions through the use of 
covered technology. The material features of a covered technology 
generally would include how the technology works, including how it 
optimizes for, predicts, guides, forecasts, or directs investment-
related behaviors or outcomes, in a manner that would enable the 
appropriate personnel at a firm to understand the potential conflicts 
of interest associated with the technology. Further, firms generally 
should include within this written description detail on when and how 
the firm intends to use, or could reasonably foresee using, the covered 
technology in investor interactions.
    To the extent that the outcomes of the technology are difficult or 
impossible to explain (e.g., in the case of a ``black box''), the 
description of how any associated conflicts arise would be critical to 
informing the application of the firm's elimination or neutralization 
procedures. As discussed above, the Commission is aware that some more 
complex covered technologies lack explainability as to how they 
function in practice, and how they reach their conclusions.\203\ The 
proposed conflicts rules would apply equally to these covered 
technologies, and firms would only be able to continue using them where 
all requirements of the proposed conflicts rules are met, including the 
requirements of paragraph (c). As discussed above, as a practical 
matter, it would be impossible for firms to use such covered 
technologies and meet the requirements of paragraph (b) of the proposed 
conflicts rules where they are unable to identify all conflicts of 
interest associated with the use of such covered technology.\204\ For 
similar reasons, if a firm is incapable of preparing this written 
description of all such conflicts of interest associated with the use 
of the covered technology in any investor interaction as a result of 
the lack of explainability of the analytical, technological, or 
computational function, algorithm, model, correlation matrix, or 
similar method or process comprising the covered technology, as well as 
its resulting outcomes, it would not be possible for the firm to 
satisfy the requirements paragraph (c) of the proposed conflicts rules. 
However, similar to the discussion above, where firms are not able to 
satisfy the requirements of paragraph (c) of the proposed conflicts 
rules with a particular covered technology in its current form, firms 
may be able to modify these technologies, for example by embedding 
explainability features into their models and adopting back-end 
controls in a manner that will enable firms to satisfy these 
requirements.\205\
---------------------------------------------------------------------------

    \203\ See supra section II.A.2.a (discussion on Evaluation and 
Identification).
    \204\ See id.
    \205\ See id.
---------------------------------------------------------------------------

    A high degree of specificity may not be necessary when creating the 
written description of every material feature of any covered technology 
used by the firm in any investor interaction. For example, if a 
material feature could not reasonably be expected to be associated with 
a conflict of interest (e.g., a financial model that is used to compute 
whether risks are sufficiently diversified in a portfolio containing 
various asset classes), a firm could reasonably determine that a simple 
description of that feature would be sufficient. However, at a minimum, 
it would need to describe the material features of the covered 
technology used by the firm at a level of detail sufficient for the 
appropriate personnel at the firm to understand whether its use would 
be associated with any conflicts of interest.
    A firm would be required to update this written description 
periodically. This requirement is designed to help ensure that firms 
are appropriately monitoring their use of covered technologies and 
accurately memorializing any material features of any covered 
technology that the firm uses in any investor interaction. These 
periodic updates to the written description should occur where a 
covered technology has been upgraded or materially modified in a manner 
that would make the previously existing written description inaccurate 
or incomplete. Additionally, if firm personnel become aware of either 
additional material features of the covered technology used by the 
firm, or of the firm engaging in a different use of the covered 
technology that was not previously contemplated by the written 
description, the written description should be updated at that time to 
include such information.
    We request comment on all aspects of this proposed written 
description requirement found in paragraph (c)(1) of the proposed 
conflicts rules, including the following items:
    67. Does the proposed conflicts rules' requirement that firms 
include written descriptions as part of their policies and procedures 
complement, overlap with, or duplicate the existing regulatory 
framework for broker-dealers and

[[Page 53993]]

investment advisers? If so, in what ways? Specifically, would firms' 
compliance with those other regulatory requirements contribute to 
compliance with the proposed conflicts rules, and vice versa?
    68. Should we require greater specificity within the written 
description as to the means a firm will use for evaluating any use or 
reasonably foreseeable potential use of covered technology in any 
investor interaction, in addition to a description of the firm's 
process for conducting such an evaluation? If so, what additional 
points of specificity should be required? Should we require less 
specificity? Does the level of specificity in the proposed requirement 
allow for sufficient flexibility to administer this aspect of the 
policies and procedures in a variety of circumstances?
    69. Should we require that the written description of the firm's 
evaluation and identification process be prepared by specific firm 
personnel or approved by firm management? If so, by whom? Similarly, 
should this written description require the designation of specific 
individuals to carry out the process firms will use for evaluating any 
use or reasonably foreseeable potential use of covered technology in 
any investor interaction?
    70. What are the challenges associated with compiling a written 
description of any material features of and any conflicts of interest 
associated with the use of any covered technology they employ? Should 
the proposed conflicts rules be revised to account for those 
challenges? If so, how?
    71. As a practical matter, firms using black box technologies would 
find it challenging, and potentially impossible, to meet the 
requirements of the proposed rules to the extent they find it difficult 
to identify and describe all conflicts of interest associated with the 
use of such covered technology. In addition to these proposed 
requirements, should we explicitly require that any technologies used 
by firms must be explainable?
    72. Is it sufficiently clear what features of a covered technology 
would constitute ``material features'' beyond those features that 
present conflicts of interest? If not, what additional detail should 
the Commission provide? Should the Commission define ``material 
features'' for the purpose of the proposed rule? For example, should 
the Commission specify as ``material features'' the types of 
recommendations or advice, or other investor interactions, a covered 
technology is designed to produce? Should the term also include the 
types of inputs, the specific methods of analysis, or the user 
interface of the technology? Why or why not?
    73. Is the proposed level of specificity and detail of the written 
description of the material features of any covered technology used by 
the firm in any investor interaction appropriate under the 
circumstances? Should the rule explicitly require that this description 
be sufficient for the appropriate personnel at the firm to understand 
whether the use of the covered technology would be associated with any 
conflicts of interest the appropriate standard? If not, what should be 
the standard? Does the level of specificity and detail still allow for 
flexible implementation in a variety of circumstances?
    74. Is the scope of covered technologies subject to this written 
description requirement appropriate in light of the requirements of 
paragraph (b) of this proposed conflicts rules? Should the proposed 
conflicts rules be modified to only require a written description of 
the material features of those covered technologies that the firm uses 
in any investor interaction that the firm has identified as containing 
at least one conflict of interest?
b. Written Description of Determination Process
    The proposed conflicts rules would also require that firms' 
policies and procedures must include a written description of the 
process for determining whether any conflict of interest identified 
pursuant to paragraph (b)(1) of the proposed conflicts rules results in 
an investor interaction that places the interest of the investment 
adviser, broker-dealer, or the firm's associated persons ahead of the 
interests of the investor.\206\ This requirement is designed to help 
ensure that firms create and implement a process for determining which 
of those conflicts of interest that they have identified in their use 
or potential use of a particular covered technology results in an 
investor interaction that would place the interests of that firm or its 
associated persons ahead of the interests of the investor. While this 
determination will ultimately depend on the individual conflict of 
interest, covered technology, related investor interactions, and other 
factors that may not be easily predictable, this process generally 
should be designed to provide a consistent approach to satisfying the 
requirements of paragraph (b)(2) of the proposed conflicts rules. In 
doing so, this written description would assist firms in performing 
this essential step to ultimately comply with the requirement in 
paragraph (b)(3) of the proposed conflicts rules to eliminate, or 
neutralize the effect of, such conflicts of interest. In addition to 
assisting the firm's internal staff, this written description would 
assist the Commission's examinations staff in assessing the firm's 
compliance with the proposed rules.
---------------------------------------------------------------------------

    \206\ Proposed conflicts rules at (c)(2).
---------------------------------------------------------------------------

    This written description generally should clearly articulate the 
process for the firm to use in determining whether any conflict of 
interest that it has identified would result in placing its own 
interests or the interests of its associated persons ahead of the 
interests of investors. Although we recognize that the idiosyncrasies 
of differing conflicts of interest or different types of investor 
interactions may necessitate some manner of flexibility as to the 
firm's process, the written description of the firm's process generally 
should be specific enough to help ensure that the process will be 
consistently effective in producing determinations by the firm that 
accurately reflect those conflicts of interest that would result in 
placing the interests of the firm or its associated persons ahead of 
the interests of investors. The process described by the firm generally 
should detail certain steps for determining the effect that the 
conflict of interest has, or would have, on an investor interaction if 
the covered technology or material modification were put into use by 
the firm. This should include a means of determining whether the 
interest of the firm, or associated person, is or would be placed ahead 
of investors' interests if the firm used the covered technology or a 
material modification to the covered technology in investor 
interactions.
    We request comment on all aspects of this proposed written 
description requirement found in paragraph (c)(2) of the proposed 
conflicts rules, including the following items:
    75. Does this aspect of the proposed conflicts rules complement, 
overlap with, or duplicate the existing regulatory framework for 
broker-dealers and investment advisers? If so, in what ways? 
Specifically, would firms' compliance with those other regulatory 
requirements contribute to compliance with the proposed conflicts 
rules, and vice versa?
    76. Should we require the written description of the firm's process 
for determining whether any conflict of interest identified pursuant to 
paragraph (b)(1) of the proposed conflicts rules results in an investor 
interaction that places the interest of the firm, or associated person, 
ahead of the interests of investors be prepared by specific firm

[[Page 53994]]

personnel or approved by firm management? If so, by whom? Similarly, 
should this written description require the designation of specific 
individuals, such as those in legal, compliance, technology, or 
managerial positions, to carry out the process firms will use for 
determining whether a particular conflict of interest places the 
interest of the firm, or associated person, ahead of the interests of 
the investor?
    77. Does the level of specificity in the proposed requirement allow 
for sufficient flexibility to administer this aspect of the policies 
and procedures in a variety of circumstances? Should we require greater 
specificity within the written description as to the means a firm will 
use for determining whether a conflict places the interest of the firm, 
or associated person, ahead of the interest of the investor, in 
addition to a description of the firm's process for making such a 
determination? If so, what additional points of specificity should be 
required? Should we instead require less specificity? If so, what 
details should not be required to be included in this written 
description?
c. Written Description of Process for Determining How To Eliminate, or 
Neutralize the Effects of, Conflicts of Interest
    The proposed conflicts rules would also require that firms' 
policies and procedures include a written description of the process 
for determining how to eliminate, or neutralize the effect of, any 
conflict of interest determined by the firm, pursuant to paragraph 
(b)(2) of the proposed conflicts rules, to result in an investor 
interaction that places the interest of the investment adviser, broker-
dealer, or the firm's associated persons ahead of the interests of the 
investor.\207\ This element is designed to require firms to have an 
established framework for eliminating, or neutralizing the effect of, 
conflicts of interest, which we believe should assist those firms in 
complying with paragraph (b)(3) of the proposed conflicts rules. The 
description will also assist the firm's internal staff, as well as 
examination staff, in assessing a firm's compliance.
---------------------------------------------------------------------------

    \207\ Proposed conflicts rules at (c)(3); see also proposed 
conflicts rules at (b)(2) requiring such determination by the firm, 
discussed supra section II.A.2.d.
---------------------------------------------------------------------------

    The process for elimination or neutralization that a firm sets 
forth in the written description should be tailored to account for the 
differing circumstances presented to the firm when making its 
determination as to a particular conflict of interest. For example, the 
process described by the firm should account for whether the particular 
conflict of interest involves a covered technology that is already 
being used in investor interactions, or instead only involves a 
conflict of interest from a reasonably foreseeable potential use. Where 
the process pertains to a reasonably foreseeable potential use, the 
firm should address how its personnel would determine whether a covered 
technology has been sufficiently modified such that any identified 
conflicts of interest have been eliminated, or their effect has been 
neutralized, prior to any use in an investor interaction. However, if 
the firm is already using the covered technology in any of its investor 
interactions, the firm's written description of this process must 
address how it would promptly eliminate, or neutralize the effect of, 
any identified conflict of interest. The written process for a covered 
technology that is already used in investor interactions might, for 
example, require the firm to immediately limit access to or use of the 
technology or, if possible, immediately eliminate the identified 
conflict of interest, prior to considering further modifications.\208\ 
In either instance, the firm would need to include a written 
description of the steps that the firm would take under its elimination 
or neutralization procedures to prevent any investor interaction that 
places the interest of the firm ahead of the interests of investors 
(e.g., by explicitly eliminating consideration of the factors that 
reflect the firm's interest, by disabling a part of the technology, by 
training it to use reinforcement learning to prioritize investors' 
interest in all cases, or by eliminating the business practice that is 
associated with the conflict).
---------------------------------------------------------------------------

    \208\ Additional discussion of how firms may eliminate, or 
neutralize the effect of, conflicts of interest may be found above 
supra section II.A.2.e.
---------------------------------------------------------------------------

    To support their efforts at compliance with the proposed conflicts 
rules, firms using covered technologies in investor interactions could 
consider providing additional training to staff who will be 
implementing their elimination and neutralization policies. For 
example, firms may benefit from providing additional training to their 
staff responsible for maintaining the covered technologies in order to 
give them a better understanding of the legal framework governing their 
firm's use of covered technologies. In addition, firms may consider 
providing additional technical training to relevant personnel, so that 
they are better able to understand how the covered technologies that 
the firm uses work, and as a result can better understand the technical 
aspects of what is necessary to eliminate or neutralize a given 
conflict of interest.
    Because a firm's policies and procedures would need to address all 
covered technologies used by the firm in any investor interaction, and 
each conflict of interest involving such covered technologies, this 
written description should contain a clear articulation of the process 
the firm uses for determining how a conflict should be eliminated or 
its effect neutralized. In addition, when a firm's policies and 
procedures dictate a specific means of making such a determination, the 
firm's written description would need to reflect this.
    We request comment on all aspects of this proposed written 
description requirement found in paragraph (c)(3) of the proposed 
conflicts rules, including the following items:
    78. Does this aspect of the proposed conflicts rules complement, 
overlap with, or duplicate the existing regulatory framework for 
broker-dealers and investment advisers? If so, in what ways? 
Specifically, would firms' compliance with those other regulatory 
requirements contribute to compliance with the proposed conflicts 
rules, and vice versa?
    79. Should we require greater specificity within the written 
description as to the means a firm will use for determining whether and 
how a conflict should be eliminated or neutralized, in addition to a 
description of the firm's process for making such a determination? If 
so, what additional points of specificity should be required? Should we 
require less specificity? Does the level of specificity in the proposed 
requirement allow for sufficient flexibility to administer this aspect 
of the policies and procedures in a variety of circumstances?
    80. Should we require that the written description of the firm's 
elimination or neutralization process be prepared by specific firm 
personnel or approved by firm management? If so, by whom? Similarly, 
should this written description require the designation of specific 
individuals to carry out the process firms will use for determining how 
a particular conflict of interest must be eliminated or neutralized?
    81. Should a firm's policies and procedures be required to 
specifically address the conduct of individuals? For example, should a 
firm's policies and procedures be required to address conflicts of 
interest where all of the benefit may accrue to one of the firm's

[[Page 53995]]

personnel, such as when firm personnel took an action that is designed 
to increase their own compensation regardless of the overall impact on 
the firm? If those persons are not registered or required to be 
registered as an investment adviser, broker, or dealer, would their 
actions otherwise be covered by the firm's policies and procedures?
d. Annual Review of the Adequacy and Effectiveness of the Policies and 
Procedures and Written Descriptions
    The proposed conflicts rules would also require that the policies 
and procedures include a review and a written documentation of that 
review, no less frequently than annually, of the adequacy of the 
policies and procedures established under the proposed conflicts rules 
and the effectiveness of their implementation, as well as a review of 
the written descriptions established pursuant to this section.\209\ 
During this review, firms would need to specifically evaluate whether 
their policies and procedures and written descriptions have been 
adequate and effective over the period under review at achieving 
compliance with the proposed conflicts rules' requirements to identify 
and evaluate all instances where their use or potential use of a 
covered technology in an investor interaction involves a conflict of 
interest, determine whether that conflict of interest places the 
interest of the investment adviser, broker-dealer, or an associated 
person of the firm ahead of those of the investor, and to then 
eliminate, or neutralize the effect of, any such conflict of interest 
promptly after the firm has, or reasonably should have, identified the 
conflict. Further, firms generally should use this annual review to 
consider whether there have been any changes in the business activities 
of the firm or its associated persons, any changes in its use of 
covered technology generally, any issues that arose from its use of 
covered technologies during the previous year, any changes in 
applicable law, or any other factor that might suggest that certain 
covered technologies now present a different or greater risk than the 
firm's policies and procedures and written descriptions had previously 
accounted for, and what adjustments might need to be made to such 
documents or their implementation to address these risks.
---------------------------------------------------------------------------

    \209\ Proposed conflicts rules at (c)(4).
---------------------------------------------------------------------------

    Firms would also be required to prepare written documentation of 
the review that they have conducted. Such documentation would serve to 
assist firms in assessing their compliance with all obligations under 
the proposed conflicts rules, and any related adjustments to their 
policies and procedures and written descriptions that might be 
necessary. To the extent that firms' annual review identifies any 
policies and procedures and written descriptions as being inadequate or 
ineffective, firms would need to make sure that they are in compliance 
with the requirement to establish and implement, and in the case of 
broker-dealers, maintain, policies and procedures that are reasonably 
designed to achieve compliance with the proposed conflicts rules.
    Under 17 CFR 275.206(4)-7 (``Advisers Act Compliance Rule''), an 
investment adviser is required to adopt and implement written policies 
and procedures reasonably designed to prevent violation, by the adviser 
and its supervised persons, of the Advisers Act and the rules 
thereunder as well as review, no less frequently than annually, the 
adequacy of the policies and procedures established pursuant to the 
Advisers Act Compliance Rule and the effectiveness of their 
implementation. Any policies and procedures an investment adviser 
adopts under the proposed conflicts rules could be reviewed in 
conjunction with the annual review under the Advisers Act Compliance 
Rule.
    While the Commission has no parallel rule requiring annual review 
of a broker-dealer's policies and procedures for their adequacy and 
effectiveness, a broker-dealer that is a FINRA member is required to 
``establish, maintain, and enforce written procedures to supervise the 
types of business in which it engages and the activities of its 
associated persons that are reasonably designed to achieve compliance 
with applicable securities laws and regulations, and with applicable 
FINRA rules.'' \210\ In addition, each FINRA member broker-dealer must 
``have its chief executive officer(s) (or equivalent officer(s)) 
certify annually . . . that the member has in place processes to 
establish, maintain, review, test and modify written compliance 
policies and written supervisory procedures reasonably designed to 
achieve compliance with applicable FINRA rules, MSRB \211\ rules and 
Federal securities laws and regulations, and that the chief executive 
officer(s) has conducted one or more meetings with the chief compliance 
officer(s) in the preceding 12 months to discuss such processes.'' 
\212\ Those broker-dealers who would be subject to the proposed 
conflicts rule could conduct this annual review in conjunction with 
their required review and certification obligations under FINRA's 
rules, in order to increase the organizational efficiency and likely 
effectiveness of this annual review.
---------------------------------------------------------------------------

    \210\ See FINRA Rule 3110(b)(1).
    \211\ Municipal Securities Rulemaking Board.
    \212\ See FINRA Rule 3130(b); see also FINRA Rule 3130(c) 
detailing procedures required for such certification.
---------------------------------------------------------------------------

    We request comment on all aspects of this proposed annual review 
requirement found in paragraph (c)(4) of the proposed conflicts rules, 
including the following items:
    82. Does this aspect of the proposed conflicts rules complement, 
overlap with, or duplicate the existing regulatory framework for 
broker-dealers and investment advisers? If so, in what ways? 
Specifically, would firms' compliance with those other regulatory 
requirements contribute to compliance with the proposed conflicts 
rules, and vice versa?
    83. Should we limit the scope of the annual review requirement for 
policies and procedures relating to certain covered technologies, or 
types of covered technologies? For example, if a covered technology has 
not changed in the past year, or if a covered technology were 
considered low risk for creating conflicts or changing since the last 
year, and the firm has not modified how it uses the covered technology, 
would it still be necessary to require firms to conduct a review in 
that area? If we were to limit the scope of the annual review 
requirement, should we require firms to monitor changes in technology 
more generally in order to be aware of whether, even if the covered 
technology itself has not changed, its interaction with other 
technologies in use by the firm could create conflicts of interest? 
What limitations would be necessary and appropriate to account for any 
risk of potential harm to investors if such limitations on the scope of 
the annual review requirement were provided?
    84. Should we require more or less frequent reviews? For example, 
monthly, quarterly, or every other year? Should we require the review 
be conducted by specific firm personnel, such as a technology 
compliance specialist? If so, by whom?

B. Proposed Recordkeeping Amendments

    We are proposing to amend rules 17a-3 and 17a-4 under the Exchange 
Act and rule 204-2 under the Advisers Act to set forth requirements for 
broker-dealers and investment advisers to

[[Page 53996]]

maintain and preserve, for the specific retention periods,\213\ all 
books and records related to the requirements of the proposed conflicts 
rules. The proposed recordkeeping amendments would also include making 
and maintaining six specific types of records discussed in detail 
below. These proposed recordkeeping amendments are designed to work in 
concert with the proposed conflicts rules to help ensure that a record 
with respect to a firm's use of covered technology is maintained and 
preserved in easily accessible locations for an appropriate period of 
time consistent with existing recordkeeping obligations.
---------------------------------------------------------------------------

    \213\ For broker-dealers, rule 17a-4(a) under the Exchange Act 
would require that records be ``preserve[d] for a period of not less 
than 6 years, the first two years in an easily accessible place.'' 
For investment advisers, rule 204-2(e)(1) under the Advisers Act 
provides that records, including those under the proposed 
recordkeeping amendments, ``shall be maintained and preserved in an 
easily accessible place for a period of not less than five years 
from the end of the fiscal year during which the last entry was made 
on such record, the first two years in an appropriate office of the 
investment adviser.''
---------------------------------------------------------------------------

    The proposed retention periods also conform to existing retention 
periods for broker-dealers and investment advisers. This approach is 
intended to allow firms to minimize their compliance costs by 
integrating the proposed requirements into their existing recordkeeping 
systems and record retention timelines. The proposed retention periods 
also conform to existing rules by having consistent requirements for 
maintaining records in an easily accessible location.\214\ And, as with 
other recordkeeping rules, the proposed recordkeeping amendments would 
help both the firm's compliance staff, as well as examinations staff 
(including relevant SRO staff, as applicable), assess the firm's 
compliance with the requirements of the proposed conflicts rules.
---------------------------------------------------------------------------

    \214\ See id.
---------------------------------------------------------------------------

    First, firms would be required to make and maintain written 
documentation of the evaluation, pursuant to paragraph (b)(1) of the 
proposed conflicts rules, of any conflict of interest associated with 
the use or potential use by the firm or associated person of a covered 
technology in any investor interaction.\215\ This written documentation 
would include a list or other record of all covered technologies used 
by the firm in investor interactions, including: (i) the date on which 
each covered technology is first implemented (i.e., first deployed), 
and each date on which any covered technology is materially modified, 
and (ii) the firm's evaluation of the intended use as compared to the 
actual use and outcome of the covered technology.\216\ Firms would also 
be required to make and maintain documentation describing any testing 
of the covered technology performed under paragraph (b)(1) of the 
proposed conflicts rules, including: (i) the date on which testing was 
completed; \217\ (ii) the methods used to conduct the testing; (iii) 
any actual or reasonably foreseeable potential conflicts of interest 
identified as a result of the testing; (iv) a description of any 
changes or modifications made to the covered technology that resulted 
from the testing and the reason for those changes; and (v) any 
restrictions placed on the use of the covered technology as a result of 
the testing.\218\ This documentation generally should include, for 
example, a record of any research or third-party outreach the firm 
conducted related to any testing of a covered technology that is 
performed under the proposed conflicts rules.
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    \215\ Proposed 17 CFR 240.17-3(e)(36)(i); 17 CFR 275.204-
2(a)(24)(i).
    \216\ See id.
    \217\ See id. We are aware that in certain cases, for example 
when complex technologies are involved, testing could take longer 
than one day. We propose that this requirement would refer to the 
date the testing was completed so that staff are able to assess 
whether the firm frequently relies on ``stale'' information.
    \218\ See id.
---------------------------------------------------------------------------

    This information would assist examinations staff, who would have a 
record they can reference when assessing compliance. This information 
also may assist firms in evaluating their initial testing methodologies 
and in evaluating and, where appropriate, remediating instances when 
the intended use or outcome of a covered technology differs from its 
actual use or outcome. In some instances, for example where the covered 
technology is using relatively straightforward mathematical models such 
as those contained in spreadsheets, firms could simply list all such 
technologies as a single entry, which we anticipate would ease firms' 
compliance with the proposed recordkeeping amendments for these 
technologies.
    Second, firms would be required to make and maintain written 
documentation of the determination, pursuant to paragraph (b)(2) of the 
proposed conflicts rules, whether any conflict of interest identified 
pursuant to paragraph (b)(1) of the proposed conflicts rules places the 
interest of the firm, or associated person of a firm, ahead of the 
interests of the investor. This would include the rationale for such 
determination.\219\ This written documentation of the rationale 
generally should include, for example, the basis on which a firm 
concludes that a conflict did or did not result in an investor 
interaction that places the firm or associated person's interests ahead 
of an investor. This information would assist examinations staff, who 
would have records they can reference when assessing compliance with 
the proposed conflicts rules. This information also may assist firms in 
determining whether actual or reasonably foreseeable potential 
conflicts of interest place the interests of the firm, or an associated 
person of the firm, ahead of the interests of the investor, as well as 
reviewing the effectiveness of the policies and procedures to achieve 
compliance with this requirement pursuant to paragraph (c).
---------------------------------------------------------------------------

    \219\ Proposed 17 CFR 240.17a-3(e)(36)(ii); 17 CFR 275.204-
2(a)(24)(ii).
---------------------------------------------------------------------------

    Third, firms would be required to make and maintain written 
documentation evidencing how the effect of any conflict of interest has 
been eliminated or neutralized pursuant to paragraph (b)(3) of the 
proposed conflicts rules.\220\ This written documentation generally 
should include a record of the specific steps taken by the firm (i.e., 
show your work) in deciding how to eliminate, or neutralize the effects 
of, any conflicts of interest as required under the proposed conflicts 
rules. The written documentation also generally should include the 
rationale for any determination to make changes or modifications to or 
place restrictions on the covered technology \221\ to eliminate, or 
neutralize the effect of, any identified conflicts of interest, the 
methodology used to make any such determination, and a description of 
the firm's analysis that resulted in any such determination. This 
information would assist examinations staff, who would have records 
they can reference when assessing compliance. This information also may 
assist firms in the determination of how to eliminate or neutralize 
conflicts of interest, as well as reviewing the effectiveness of the 
policies and procedures to achieve compliance with this requirement 
pursuant to paragraph (c).
---------------------------------------------------------------------------

    \220\ Proposed 17 CFR 240.17a-3(e)(36)(iii); 17 CFR 275.204-
2(a)(24)(iii).
    \221\ See proposed 17 CFR 240.17a-3(e)(36)(i); 17 CFR 275.204-
2(a)(24)(i).
---------------------------------------------------------------------------

    Fourth, firms would be required to maintain the written policies 
and procedures, including any written descriptions, adopted, 
implemented, and, with regard to broker-dealers, maintained pursuant to 
paragraph (c) of the proposed conflicts rules.\222\ This documentation 
would include the date

[[Page 53997]]

on which the policies and procedures were last reviewed.\223\ Firms 
must also maintain written documentation evidencing a review, occurring 
at least annually, of the adequacy of the policies and procedures 
established pursuant to paragraph (c) of the proposed conflicts rules, 
and the effectiveness of their implementation, as well as a review of 
the written descriptions established pursuant to paragraph (c) of the 
proposed conflicts rules. These provisions would assist examinations 
staff in assessing firms' compliance with the proposed conflicts rules.
---------------------------------------------------------------------------

    \222\ Proposed 17 CFR 240.17a-3(e)(36)(iv); 17 CFR 275.204-
2(a)(24)(iv).
    \223\ See id.
---------------------------------------------------------------------------

    To help demonstrate compliance with the proposed conflicts rules, a 
firm may elect to maintain records documenting other information 
regarding covered technology, which could help to demonstrate that it 
took a reasonable approach when identifying and evaluating the 
conflicts of interest associated with the technology. For example, a 
firm may choose to maintain a record of any uses, other than in 
investor interactions, that the firm reasonably foresees for each 
covered technology.\224\
---------------------------------------------------------------------------

    \224\ See id.
---------------------------------------------------------------------------

    Fifth, firms would be required to make and maintain a record of any 
disclosures provided to investors regarding the firm's use of covered 
technologies, including, if applicable, the date such disclosure was 
first provided or the date such disclosure was updated.\225\ We do not 
intend this proposed requirement to impose new disclosure requirements, 
nor do we intend that firms maintain documents in two locations. Many 
firms could satisfy this proposed requirement by maintaining a simple 
bullet-point list with cross-references to all disclosures they make to 
investors regarding their use of covered technologies (whether the 
disclosure is made pursuant to an existing requirement or voluntarily). 
Maintaining a list of any such disclosures would assist examinations 
staff in reviewing disclosures given to investors regarding a firm's 
use of covered technologies, to help ensure that these disclosures are 
full and fair.
---------------------------------------------------------------------------

    \225\ Proposed 17 CFR 240.17a-3(e)(36)(v); 17 CFR 275.204-
2(a)(24)(v).
---------------------------------------------------------------------------

    Sixth, firms would be required to make and maintain records of each 
instance in which a covered technology was altered, overridden, or 
disabled; the reason for such action; and the date thereof. This 
requirement would include making and maintaining records of all 
instances where an investor requested that a covered technology be 
altered or restricted in any manner.\226\ We believe these records will 
assist in identifying which technologies may present higher risks, for 
example if they require constant alterations or if certain investors 
request that such technologies not be used on their accounts.
---------------------------------------------------------------------------

    \226\ Proposed 17 CFR 240.17a-3(e)(36)(vi); 17 CFR 275.204-
2(a)(24)(vi).
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed recordkeeping 
amendments, including the following items:
    85. Do the proposed recordkeeping amendments complement, overlap 
with, or duplicate the existing regulatory framework for broker-dealers 
and investment advisers? If so, in what ways? Specifically, would 
firms' compliance with those other regulatory requirements contribute 
to compliance with the proposed recordkeeping amendments, and vice 
versa?
    86. Are there additional records that firms would naturally create 
as they complied with the proposed conflicts rules that we should 
require them to maintain? Are there any records beyond what firms would 
already naturally create that would be useful to require them to 
maintain? Should we require fewer records? If so, which ones should we 
eliminate and why?
    87. Would the records that firms would be required to make and 
retain under the proposed recordkeeping amendments likely require firms 
to retain additional ``backup'' documentation, such as logs, training 
data, or other documentation? Should we make any changes as a result? 
For example, should we explicitly require such information to be made 
and retained? Are there reasons such information should not be required 
to be made and retained? For example, is it likely that such 
information would be voluminous, and could therefore be difficult for 
firms to retain for the full timeframe that records would be required 
to be maintained? If so, should we reduce the time that firms would be 
required to retain such records?
    88. For records related to all instances where an investor 
requested that a covered technology be altered or restricted, what 
challenges would firms face with respect to maintaining this 
information? What factors should we consider if we qualify this 
requirement?
    89. Are the proposed periods of time for preserving records 
appropriate, or should certain records be preserved for different 
periods of time? If records should be preserved for different periods 
of time, which records should have different time periods and what 
should those periods of time be?
    90. We are proposing to require broker-dealers and investment 
advisers to maintain the same records. Are there any differences in the 
way that investment advisers and broker-dealers conduct business that 
would advocate for maintaining different sets of records?
    91. Should the proposed recordkeeping requirement that advisers 
maintain records of all instances where an investor requested that a 
covered technology be altered or restricted in any manner apply to 
prospective clients and prospective investors in a pooled investment 
vehicle? Should an investment adviser be required to maintain a record 
of instances where a prospective client or prospective investor in a 
pooled investment vehicle requested that the covered technology be 
altered or restricted, but the investment adviser rejected the request, 
and the prospective client did not ultimately invest?
    92. We are proposing to require firms to maintain a record of any 
disclosures provided to each investor regarding the firm's use of 
covered technologies. Should the proposed recordkeeping amendments 
require specific disclosures to be provided or maintained? If so, what 
disclosures? Should the disclosures be limited to use of covered 
technologies in investor interactions, or be broadened to include more 
technology? Should we also require records of disclosures about a 
firm's or associated person's conflicts associated with the use of such 
technologies in investor interactions?
    93. We are proposing to require firms to make and maintain 
documentation describing any testing of the covered technology 
performed under paragraph (b)(1) of the proposed conflicts rules. Along 
with the existing specifics, should we also require information about 
who developed and/or conducted the testing (e.g., firm personnel, an 
outside vendor)?

III. Economic Analysis

A. Introduction

    The Commission is sensitive to the economic consequences and 
effects, including costs and benefits, of its rules. Section 3(f) of 
the Exchange Act \227\ and section 202(c) of the Advisers Act \228\ 
provide that when engaging in rulemaking that requires it to consider 
or determine whether an action is necessary or appropriate in the 
public interest, the Commission shall also consider, in addition to the 
protection of investors, whether the action will

[[Page 53998]]

promote efficiency, competition, and capital formation. Additionally, 
section 23(a)(2) of the Exchange Act \229\ requires the Commission, 
when making rules under the Exchange Act, to consider the impact such 
rules would have on competition. Section 23(a)(2) also provides that 
the Commission shall not adopt any rule which would impose a burden on 
competition that is not necessary or appropriate in furtherance of the 
purposes of the Exchange Act.
---------------------------------------------------------------------------

    \227\ 15 U.S.C. 78c(f).
    \228\ 15 U.S.C. 80b-2(c).
    \229\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    The analysis below addresses the likely economic effects of the 
proposed conflicts rules and proposed recordkeeping amendments, 
including the anticipated benefits and costs of the proposed rules and 
amendments, and their likely effects on efficiency, competition, and 
capital formation. Where practicable, the Commission quantifies the 
likely economic effects of the proposed rules and amendments; however, 
the Commission is unable to quantify certain economic effects because 
it lacks the information necessary to provide estimates or ranges. Some 
of the benefits and costs discussed below are impracticable to quantify 
because quantification would necessitate general assumptions about 
behavioral responses that would be difficult to quantify. The 
Commission is providing both a qualitative assessment and, where 
feasible, a quantified estimate of the economic effects. The Commission 
seeks comment on any data that could aid quantification of these 
responses.
    The proposed conflicts rules and proposed recordkeeping amendments 
may have economic implications for investors, investment advisers, and 
broker-dealers, and could also affect third-party service providers. 
The proposed conflicts rules would introduce requirements to identify 
conflicts of interest associated with the use of covered technologies 
in investor interactions and eliminate or neutralize those conflicts 
that place or result in placing the interest of the firm or associated 
person ahead of the interest of the investor, as well as proposed 
recordkeeping requirements regarding such determinations and resulting 
actions. This economic analysis aims to examine the potential benefits 
and costs of the proposed rules and amendments and the impact the 
proposed rules and amendments may have on the market's efficiency, 
competition, and capital formation.

B. Broad Economic Considerations

    In the last two decades and after the proliferation of internet-
based services, the advent of new technologies has modified the 
business operations of broker-dealers and investment advisers.\230\ 
Access to cheaper and more granular data, plus the additional 
availability of advanced computing power, have advanced data collection 
and processing techniques. These developments have significantly 
enhanced the scale and scope of data analytics and their potential 
applications by investment advisers and broker-dealers in their 
interactions with investors. These advances have increased the ability 
of each of these investor interactions to contain conflicted conduct, 
given the more widespread availability of data about investors, 
advances in user interface design and gamification, and business 
practices that could place the firm's or an associated person's 
interest ahead of investors' interests. Also, some PDA-like 
technologies are now able to update their interactions with investors 
dynamically, based on information or data they have gained from their 
users or from other data sources, which can dynamically alter the 
nature and scope of conflicts of interest.
---------------------------------------------------------------------------

    \230\ See supra section I.B.
---------------------------------------------------------------------------

    The capabilities of these technological advances--including the 
data the technology uses (including any investor data) and the 
inferences the technology makes (including in analyzing investor data, 
other data, securities, or other assets)--may be opaque to investors 
and firms. This opacity makes it more challenging for an investor to 
identify the presence of a conflict of interest, understand its 
importance, and take protective action when making an investment 
decision or otherwise interacting with the firm. Likewise, a firm's 
identification of such conflicts is more challenging without unique 
efforts to both fully understand the PDA-like technology it is using 
and oversee conflicts that are created by or transmitted through such 
technology for purposes of the firm's compliance with applicable 
Federal securities laws. Further, PDA-like technologies can have the 
capacity to process data, scale outcomes from analysis of data, and 
evolve at incredibly rapid rates. These traits could rapidly and 
exponentially scale the effects of any conflicts of interest associated 
with such technologies, which could impact the markets more 
broadly.\231\
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    \231\ See supra sections I.A and I.B. For example, a firm may 
use PDA-like technologies to automatically develop advice and 
recommendations that are then transmitted to investors through the 
firm's chatbot, mobile trading app, and robo-advisory platform. If 
the advice or recommendation is tainted by a conflict of interest, 
that conflict would rapidly reach many investors. See supra note 16 
and surrounding text.
---------------------------------------------------------------------------

    The Commission considered two broad economic themes raised by 
firms' use of covered technology in investor interactions. First, the 
use of covered technology in investor interactions can entail conflicts 
of interest related to the principal-agent problem between firms and 
investors, and second, the use of complex and opaque technologies can 
potentially create events that can harm investors.\232\
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    \232\ The proposed conflicts rules' definition of ``conflict of 
interest'' is broader than how economists usually define ``conflicts 
of interest'' such as in the context of the principal-agent problem. 
One economist's definition of ``conflict of interest'' is ``a 
situation in which a party to a transaction can potentially gain by 
taking actions that adversely affect its counterparty.'' Hamid 
Mehran & Ren[eacute] M. Stulz, The Economics of Conflicts of 
Interest in Financial Institutions, 85 J. Fin. Econ. 267-296 (Aug. 
2007).
---------------------------------------------------------------------------

    The principal-agent problem arises when one party, known as the 
principal, hires an agent to perform a task on the principal's behalf, 
but the interests of the principal and the agent are not aligned.\233\ 
The principal-agent problem can result in the agent acting in its own 
self-interest ahead of the principal's interest. This problem is 
particularly relevant in the financial industry, where firms manage 
investments or execute orders on behalf of investors in exchange for 
fees. Firms usually have more information about the investments they 
are recommending, pricing, and market dynamics than the investors that 
they serve, and can potentially place their interests ahead of 
investors' interests. Similarly, firms can encourage investors to use 
more services, or increase transactions, potentially placing the firm's 
interest over investors' interests. These conflicts of interest are 
exacerbated by firms' use of certain covered technologies because the 
technologies that firms use may be complex and opaque to investors, who 
may not have the knowledge or time to understand how firms' use of 
these technologies may generate conflicts of interest in their 
interactions with investors. If these conflicts of interest were left 
unaddressed, investors could be harmed by less efficient investment

[[Page 53999]]

strategies \234\ and incur agency costs.\235\ This could also adversely 
affect the formation of capital, as investors might choose to invest 
less or might lose confidence in capital markets.
---------------------------------------------------------------------------

    \233\ Michael C. Jensen & William H. Meckling, Theory of the 
Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 
J. Fin. Econ. 305 (1976) (``Jensen & Meckling'').
    \234\ A rational investor seeks out investment strategies that 
are efficient in the sense that they provide the investor with the 
highest possible expected net benefit, in light of the investor's 
investment objective that maximizes expected utility. See, e.g., 
Andreu Mas-Colell, Michael D. Whinston & Jerry R. Green, Chapter 10: 
Competitive Markets for a Discussion of Efficient Allocations of 
Resources, in Microeconomic Theory (1995).
    \235\ The difference between the net benefit to the investor 
from accepting a less than efficient recommendation about a 
securities transaction or investment strategy, where the associated 
person or broker-dealer puts its interests ahead of the interests of 
the investor's interests, and the net benefit the investor might 
expect from a similar securities transaction or investment strategy 
that is efficient for him or her, is an agency cost. See, e.g., 
Jensen & Meckling, supra note 233 for a more general discussion of 
agency costs.
---------------------------------------------------------------------------

    Disclosure can sometimes help address conflict of interest problems 
in principal-agent relationships. When firms fully and fairly disclose 
conflicts of interest, investors may be able to make informed decisions 
about their investments. For example, investment advisers are required 
to provide clients with a Form ADV, which details information about the 
adviser's business practices, fees, and certain conflicts of 
interest.\236\ The Commission has brought enforcement actions against 
broker-dealers that failed to disclose certain conflicts to 
customers.\237\ In addition, investment advisers and broker-dealers are 
required to provide ``retail investors'' with Form CRS, which explains 
fees, commissions, and other information that may be relevant when 
choosing a firm.\238\ These disclosure requirements provide investors 
with information that may help them choose among firms. They also help 
to create a more transparent relationship between a firm and its 
investors and potentially help investors assess whether investment 
advisers and broker-dealers are placing their own interests ahead of 
their investors' interests. In section III.C.3, we discuss the current 
disclosures that investment advisers and broker-dealers are required to 
make in addition to other obligations, and in section III.D.1, we 
discuss why we believe disclosure is unlikely to be sufficient to 
address the principal-agent problems generated by covered 
technologies.\239\
---------------------------------------------------------------------------

    \236\ Amendments to Form ADV, Investment Adviser Act Release No. 
3060 (July 28, 2010) [75 FR 49233 (Aug. 12, 2010)] (``Amendments to 
Form ADV'').
    \237\ See supra note 64.
    \238\ Fiduciary Interpretation, supra note 8.
    \239\ See also Reg BI Adopting Release, supra note 8, at 
III.B.4.c. (discussing the effectiveness and limitations of 
disclosure).
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    Firms may adopt certain DEPs in the use of covered technology in 
investor interactions that can exploit common biases or tendencies in 
investors and lead these investors to make investment decisions that 
will place the firm's interest ahead of investors' interests.\240\ 
These practices can exacerbate the principal-agent problem, as 
disclosure might not be as effective at addressing the misaligned 
incentives between the firm and the investor. For example, firms could 
use demographic information about an investor or their risk-taking 
behavior to encourage them to take actions that place the firm's 
interest ahead of the investors' interest.\241\ These could be actions 
such as trading unnecessarily, allowing the firm to collect extra fees 
or payments from the additional trading activity (e.g., through 
increased commissions or payment for order flow) or investing in 
riskier positions that are more profitable to the firm.\242\
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    \240\ Ontario Securities Commission, Staff Notice 11-796, 
Digital Engagement Practices in Retail Investing: Gamification and 
Other Behavioural Techniques (2022), https://www.osc.ca/sites/default/files/2022-11/sn_20221117_11-796_gamification-report.pdf. 
George M. Korniotis & Alok Kumar, Do Portfolio Distortions Reflect 
Superior Information or Psychological Biases?, 48 J. Fin. Quant. 
Analysis 1 (2013) (``Korniotis''); Thomas Dohmen et al., Individual 
Risk Attitudes: Measurement, Determinants, and Behavioral 
Consequences, 9 J. Eur. Econ. Ass'n 522-550 (June 2011) (``Thomas 
Dohmen et al.''); Brad M. Barber & Terrance Odean, Trading Is 
Hazardous to Your Wealth: The Common Stock Investment Performance of 
Individual Investors, 55 J. Fin. 773-806 (2000) (``Trading Is 
Hazardous''); Brad M. Barber & Terrance Odean, Boys Will Be Boys: 
Gender, Overconfidence, and Common Stock Investment, 116 Q. J. Econ. 
261-292 (Feb. 2001) (``Boys Will Be Boys''); Marie Grall-Bronnec et 
al., Excessive Trading, a Gambling Disorder in its Own Right? A Case 
Study on a French Disordered Gamblers Cohort, 64 Addictive Behav. 
340-348 (Jan. 2017); M. Mosenhauer, et al., The Stock Market as a 
Casino: Associations Between Stock Market Trading Frequency and 
Problem Gambling, 10 J. Behav. Addictions 683-689 (Sept. 2021); Alex 
Bradley & Richard JE James, Defining the Key Issues Discussed by 
Problematic Gamblers on Web-based Forums: A Data-driven Approach, 21 
Int'l Gambling Stud. 59-73 (2021).
    \241\ For example, attitudes toward risk and risk-taking 
behavior have been found to be meaningfully predicted by sex, age, 
height, and parental educational achievement. See Dohmen, et al., 
supra note 240.
    \242\ Korniotis, supra note 240.
---------------------------------------------------------------------------

    Studies have shown, for example, that excess trading has a negative 
impact on investment returns, with frequent traders exhibiting lower 
net annual returns than infrequent traders due to overconfidence.\243\ 
Other studies have found that some stock trading apps appear to follow 
strategies employed by some firms in the gambling industry to encourage 
frequent repeat betting,\244\ obscure costs, and offer complex 
instruments with lottery-like large payoffs in rare cases, and that 
these behavior-influencing strategies benefit from survivorship 
bias.\245\ These practices might not constitute recommendations, and 
therefore might not face the same obligations that recommendations 
would. In addition, given that these strategies exploit psychological 
biases and innate tendencies of the investor rather than information 
deficiencies or asymmetries, even comprehensive, accurate, and legible 
disclosure might be less effective at ensuring disinterested investor 
interactions, including recommendations, which do not place the firm's 
interest above that of investors.\246\ Firms could profit from these 
strategies through increased fees or payment for order flow due to 
higher transaction frequency and higher fees on more complex trades, 
among other means. In contrast to these strategies, initial efforts at 
design research as applied to financial applications identified several 
practices that could improve investor thoughtfulness and informed 
decision-making.\247\
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    \243\ See, e.g., Trading is Hazardous, supra note 240.
    \244\ Philip W.S. Newall & Leonardo Weiss-Cohen, The 
Gamblification of Investing: How a New Generation of Investors Is 
Being Born to Lose, 19 Int. J. Env't. Res. Pub. Health (Apr. 28, 
2022).
    \245\ M.W. Brandt & J.A. Gaspar, Trading on Margin: The Effect 
of Financial Market Information Services and Trading Apps on Day 
Trading Behavior, 33 Rev. Fin. Stud. 2331-2372 (2020).
    \246\ Human behavior exhibits conditioned responses. See William 
S. Verplanck, The operant conditioning of human motor behavior, 53 
Psychological Bulletin 70 (1956). Moreover, the anticipation of 
monetary rewards creates similar neural circuitry to anticipation of 
primary rewards in other primates. See B. Knutson et al., FMRI 
visualization of brain activity during a monetary incentive delay 
task, 12 Neuroimage, 20-27 (2000).
    \247\ Chaudhury & Kulkarni, supra note 53, at 777-788.
---------------------------------------------------------------------------

    The scale and scope of investor interactions that are now possible 
with new technologies, and the scope and dynamic nature of the 
conflicts of interest that can be generated by or associated with 
firms' use of covered technology, present challenges for the use of 
disclosure to address conflicts of interest. A single, large disclosure 
at the beginning of the firm's relationship with the investor might be 
too lengthy to be meaningful or actionable, or not specific enough to 
be effective, because it would have to capture the full set of 
conflicts of interest that could evolve dynamically, across investors, 
through the use of PDA-like technologies, especially if the technology 
rapidly adjusts in response to prior interactions

[[Page 54000]]

with an investor.\248\ Alternatively, attaching a disclosure to each 
individual investor interaction could address the potential for 
conflicts of interest that are dynamically generated through the use of 
PDA. However, the overall large number of disclosures would impose 
costs on firms and investors, and effectiveness of these disclosures 
might be reduced because of the sheer quantity of disclosures.\249\
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    \248\ See e.g., Maartje Elshout, et al., Study on consumers' 
attitudes towards Terms and Conditions (T&Cs), European Commission 
Final Report (2016); Uri Benoliel & Shmuel I. Becher, The Duty to 
Read the Unreadable, 60 B. C. L. Rev. 2255 (2019); Yannis Bakos, et 
al., Does Anyone Read the Fine Print? Consumer Attention to 
Standard-Form Contracts, 43 J. Legal Stud. 1 (2014).
    \249\ Due to the potential scalability of these disclosures, 
incremental costs for firms might be de minimis, but these 
disclosures would still take costly effort by investors to 
interpret.
---------------------------------------------------------------------------

    Firms' use of PDA-like technologies could also impact markets more 
broadly, because these technologies can process data and amend 
analytical outcomes at incredibly fast rates, thereby creating 
unanticipated conflicts of interest that can affect numerous investors, 
and create market disruptions that affect market participants 
broadly.\250\ A given firm might not fully bear the cost of the use of 
these technologies, and thus might not fully internalize the full cost 
of the use of these technologies. The costs imposed on entities 
external to the firm are called negative externalities, and regulatory 
intervention may be needed to address these costs.
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    \250\ SEC Staff Report, Equity and Options Market Structure 
Conditions in Early 2021 (Oct. 4, 2021) (``GameStop Report''), 
https://www.sec.gov/files/staff-report-equity-options-market-struction-conditions-early-2021.pdf.
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C. Economic Baseline

1. Affected Parties
    Broadly, the proposed rules would affect investment advisers, 
broker-dealers, and investors. They could also indirectly affect third-
party service providers that provide covered technologies used by these 
parties.
    As of February 28, 2023, there were 15,402 investment advisers 
registered with the Commission \251\ and 3,504 broker-dealers 
registered with the Commission.\252\ There were 308,565 individuals 
registered with FINRA as broker-dealer representatives only, 80,977 
individuals registered as investment adviser representatives only, 
312,317 individuals registered as both investment adviser and broker-
dealer representatives, and a total of 971,758 employees reported by 
investment advisers.\253\ However, because the proposed rules would 
also affect associated persons of firms these numbers may undercount 
the number of affected individuals, because not all associated persons 
of a firm are registered representatives of the firm. Approximately 
73.5% of registered broker-dealers report retail customer 
activity.\254\
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    \251\ Based on IARD data as of Mar. 27, 2023.
    \252\ Based on SEC data as of Mar. 1, 2023, https://www.sec.gov/help/foiadocsbdfoia.
    \253\ Based on FOCUS Filing data, as of March 2023.
    \254\ Consistent with the Form CRS Adopting Release, we estimate 
that 73.5% of registered broker-dealers report retail activity and 
thus, would likely be subject to the proposed conflicts rule. 
However, we recognize this may capture some broker-dealers that do 
not have retail activity.
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    Form ADV requires investment advisers to indicate the approximate 
number of advisory clients and the amount of total regulatory assets 
under management (``RAUM'') attributable to various client types.\255\ 
Table 1 provides information on the number of client accounts, total 
RAUM, and the number of advisers by client type.
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    \255\ If a client fits into more than one category, Form ADV 
requires an adviser to select one category that most accurately 
represents the client (to avoid double counting clients and assets).
    \256\ This report reflects analysis of Form ADV data downloaded 
from the Enterprise Data Warehouse as of February 28, 2023. Form 
ADV, Items 5C, 5D, and 5F(2)(c). Prior to the October 2017 changes 
to Form ADV, clients and client RAUM were estimated based on the 
midpoint of ranges reported.

                           Table 1--Clients of Investment Advisers From Form ADV \256\
----------------------------------------------------------------------------------------------------------------
                                                                    Total RAUM        Clients
                           Client type                              (billions)      (millions)         RIAs
----------------------------------------------------------------------------------------------------------------
Investment Companies............................................         $42,955           0.022           1,565
Pooled Investment Vehicles--Other...............................          34,433           0.094           5,897
High Net Worth Individuals......................................          11,664           6.898           9,166
Pension Plans...................................................           7,807           0.442           5,429
Insurance Companies.............................................           7,623           0.015           1,381
Non-High Net Worth Individuals..................................           7,030          44.092           8,493
State/Municipal Entities........................................           4,214           0.029           1,608
Corporations....................................................           3,198           0.348           5,196
Foreign Institutions............................................           2,194           0.003             752
Charities.......................................................           1,580           0.127           5,369
Other Advisers..................................................           1,385           0.904           1,202
Banking Institutions............................................             903           0.011             825
Business Development Companies..................................             213           0.000              97
----------------------------------------------------------------------------------------------------------------

    As of February 2023, 50,554 private funds were reported on Form PF, 
and 5,620 registered investment advisers listed private funds on their 
Form ADV.\257\ The effects of the proposed rules to firms and 
associated persons would be contingent on a number of factors, such as, 
among others, the types of covered technologies the firm uses, the 
number of current and prospective clients or customers of the firm, the 
number of investors in pooled investment vehicles advised by the firm, 
the frequency of investor interactions, and the nature and extent of 
the conflicts of interest. Because of the wide diversity of services 
and relationships offered by firms, we expect that the obligations 
imposed by the proposed rules would, accordingly, vary substantially. 
The Commission seeks public comment on the number and type of these 
affected parties. When developing the baseline, we considered how 
current trends in technological development and the conflicts 
associated with them might reasonably affect financial markets in the 
absence of the proposed rules. The Commission invites public comment on 
our characterization of these trends in the baseline.
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    \257\ SEC, Div. of Investment Mgmt, Analytics Office, Private 
Funds Statistics Third Calendar Quarter 2022, (Apr. 6, 2023).
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    The proposed rules would affect investors. As discussed earlier in 
this release, the proposed rules would define ``investor'' differently 
for investment

[[Page 54001]]

advisers as compared to broker-dealers. For investment advisers, 
``investor'' is defined as any prospective or current client of an 
investment adviser or any prospective or current investor in a pooled 
investment vehicle advised by the investment adviser. For broker-
dealers, ``investor'' is defined to mean a natural person, or the legal 
representative of such natural person, who seeks to receive or receives 
services primarily for personal, family or household purposes. This 
definition is identical to the one used for ``retail investor'' in Form 
CRS, and it excludes non-retail investors of broker-dealers.
    According to the Federal Reserve Board's 2019 Survey of Consumer 
Finances, a total of 41.3 million U.S. households have either an 
individual retirement account (``IRA'') or a brokerage account; an 
estimated 23.0 million U.S. households have a brokerage account, and 
32.7 million households have an IRA (including 63% of households that 
also hold a brokerage account).\258\ Households have increased their 
use of business professionals for investment decisions, rising from 
48.9 percent in 2001 to 56.5 percent in 2019. In addition, household 
use of the internet for investment decisions has risen from 14.8 
percent in 2001 to 45.2 percent in 2019.\259\ A 2019 survey of 
households found that approximately 10 million U.S. households use 
robo-advisers.\260\ In 2022, the top 10 robo-advisers reported $353.2 
billion in assets under management.\261\ The Commission seeks comment 
on the number of investors this definition could cause to be affected 
by the proposed conflicts rules, and the extent and nature of the use 
of covered technologies.
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    \258\ The data is obtained from the Federal Reserve System's 
2019 Survey of Consumer Finances (``SCF''). See Board of Governors 
of the Fed. Rsrv. Sys., Survey of Consumer Finances (2019), https://www.federalreserve.gov/econres/scfindex.htm.
    \259\ See Neil Bhutta et al., Board of Governors of the Fed. 
Rsrv. Sys., 106 Fed. Rsrv. Bulletin 31 (Sept. 2020) (``Business 
professionals'' combines seven options: accountant, banker, broker, 
financial planner, insurance agent, lawyer, and real estate agent).
    \260\ Michael Mackenzie, Demand for Advice Rises as Not All 
Investors Go It Alone, Fin. Times (Sept. 13, 2020), https://www.ft.com/content/3900c943-245a-424d-b2e5-da6128655ed5.
    \261\ Barbara Friedberg, Top-10 Robo-Advisors by Assets under 
Management, Forbes Advisor (July 9, 2022), https://www.forbes.com/advisor/investing/top-robo-advisors-by-aum/.
---------------------------------------------------------------------------

    The proposed conflicts rules may indirectly affect third-party 
service providers of covered technologies. A firm may be using a 
covered technology developed by a third-party service provider, 
including through some license agreement with the third-party service 
provider. A firm may also outsource certain functionality of the 
covered technology to, or utilize the support or services of, a third-
party provider for a variety of reasons, including cost efficiencies, 
increased automation, particular expertise, or functionality that the 
firm does not have in-house.
    Based on Commission staff experience, the Commission believes that 
these third-party providers play a growing role with respect to the 
development of covered technologies, and the Commission anticipates 
that third-party providers will likely arise to provide other types of 
functionality, service, or support to firms that are not contemplated 
yet today.
    Due to data limitations, we are unable to quantify or characterize 
in much detail the structure of these various service provider markets. 
The Commission lacks specific information on the exact extent to which 
third-party service providers are retained, the specific services they 
provide, and the costs for those services. We also do not have 
information about the market for these services, including the 
competitiveness of such markets. We request information from commenters 
on the services related to covered technologies provided by third 
parties to firms, the costs for those services, and the nature of the 
market for these services.
    2. Technology and Market Practices
    The use of technology in investing has undergone significant 
transformation in recent years.\262\ Some firms and investors in 
financial markets now use new technologies such as AI, machine 
learning, NLP, and chatbot technologies to communicate and make 
investment decisions.\263\ In addition, improvements and new 
applications for existing technologies for data-analytics, data 
collection, and investor interaction continue to be developed.\264\
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    \262\ See supra section I.A; see Shaw & Gani, supra note 75.
    \263\ Kearns & Nevmyvaka, supra note 24; Thier & dos Santos 
Monteiro, supra note 24.
    \264\ Lekh & P[aacute]tek, supra note 25; Martindale, supra note 
25.
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    Financial market participants currently use AI and machine learning 
technologies in a variety of ways. For example, algorithmic trading is 
a widely used application of machine learning in finance, where 
machine-learning models analyze large datasets and identify patterns 
and signals to optimize, forecast, predict, guide, or direct 
investment-related behaviors or outcomes.\265\ Several banks and other 
financial institutions have developed chatbots to assist with customer 
service and support, and have attempted to make the chatbot 
interactions feel similar to conversations with humans.\266\ These 
chatbots can help customers with a range of tasks, from checking 
account balances and transactions to making payments and disputing 
fraudulent charges. NLP is used to analyze financial news and social 
media data, identifying trends and sentiment that may influence market 
behavior. For instance, hedge funds and trading firms use NLP tools to 
analyze financial news articles, press releases, and social media posts 
in real-time, to identify patterns and make trading decisions based on 
sentiment analysis.\267\ Some robo-advisers use chatbots and NLP 
technology to provide investment advice via online platforms.\268\ 
These platforms may use a combination of AI, machine learning, NLP, and 
chatbot technologies to provide personalized investment recommendations 
to investors based on risk tolerance and investment goals.
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    \265\ Forecasting in contexts contemplated by these rules, such 
as machine learning, involves estimation of a future value based on 
data which includes a temporal component. Prediction, in contrast, 
is the more general estimation of unknown data from known data, for 
example, missing words in a transcript. See, e.g., Mattias 
D[ouml]ring, Prediction vs Forecasting, Data Science Blog (Dec. 9, 
2018), https://www.datascienceblog.net/post/machine-learning/forecasting_vs_prediction/.
    \266\ See, e.g., Suman Bhattacharyya, Bank of America Wants a 
Human Bridge for Its AI Help, BankingDive (Dec. 12, 2022), https://www.bankingdive.com/news/bank-america-erica-chatbot-virtual-assistant-human-middle-interaction-gopalkrishnan/638523/; Sara 
Castellanos, Capital One Brings `Humanity' to Its Forthcoming 
Chatbot, CIO Blog (July 19, 2017), https://www.wsj.com/articles/capital-one-brings-humanity-to-its-forthcoming-chatbot-1500488098 
(retrieved from Factiva database); Moise, supra note 24.
    \267\ See, e.g., Patrick Henry & Dilip Krishna, Making the 
Investment Decision Process More Naturally Intelligent, Deloitte 
Insights (Mar. 2, 2021), https://www2.deloitte.com/us/en/insights/industry/financial-services/natural-language-processing-investment-management.html; see also Yong Chen et al., Sentiment Trading and 
Hedge Fund Returns, 76 J. Fin. 2001 (Apr. 8, 2011).
    \268\ See supra note 41 and surrounding text.
---------------------------------------------------------------------------

    Recent advancements in data collection techniques have 
significantly enhanced the scale and scope of data analytics and its 
potential applications. Thanks to increases in processing power and 
data storage capacity, a vast amount of data is now available for high-
speed analysis using these technologies.\269\ Furthermore, the range of 
data types has also expanded, with consumer shopping

[[Page 54002]]

histories, media preferences, and online behavior now among the many 
types of data that data analytics can use to synthesize information, 
forecast financial outcomes, and predict investor and customer 
behavior.\270\ As a result, these technologies can be applied in novel 
and powerful, yet subtle ways, such as using data layout and formatting 
choices to influence trading decisions.\271\ Some technologies use 
predictive data analytics and AI/machine learning along with detailed 
user data to increase user engagement, and trading activity.
---------------------------------------------------------------------------

    \269\ See, e.g., Andriosopoulos et al., supra note 51; Lawler et 
al., supra note 51; Alex Padalka, Tech Firms Court Fidelity for Data 
Heap to Build AI Systems, Fin. Advisor IQ (June 8, 2023), https://www.financialadvisoriq.com/c/4104954/529084/tech_firms_court_fidelity_data_heap_build_systems.
    \270\ Daniel Broby, supra note 52; OECD, supra note 52.
    \271\ See Chaudhuri & Kulkarni, supra note 53.
---------------------------------------------------------------------------

    The use of these technologies can generate conflicts of interest if 
firms use these technologies to suggest or nudge users to trade more 
frequently on their platform, or to invest in products that are more 
profitable for the firm but expose investors to higher costs or risks, 
against investors' interests. In addition, although investors are free 
to choose a firm that uses technology in a manner with which they are 
comfortable, investors may have to undertake costly efforts to 
understand how firms are using technology and to be comfortable with 
newer technologies used by firms, including any associated disclosures 
of conflicts of interest. In the case of broker-dealers, non-
recommendation interactions with investors are not subject to Reg BI's 
Conflict of Interest Obligation, but can still influence investor 
behavior in a way that places the firm's interests ahead of investors' 
interests.
    Many of these technologies are not directly developed by investment 
advisers or broker-dealers, but are instead licensed from third party 
providers.\272\ This practice can harness the economies of scale in the 
development and testing of a technology with broad applications, by 
centralizing the costs within the service provider, rather than 
spreading the costs across multiple firms independently developing 
similar technologies. However, the use of third party providers can 
also potentially concentrate the risks that stem from conflicts of 
interest from the use of these technologies if such providers are 
concentrated within the market serving covered entities and provide 
products or services which operate broadly similarly across their 
covered customers.
---------------------------------------------------------------------------

    \272\ See, e.g., Karl Flinders, Banks Don't Want to Develop 
Fintech In-house, Computer Wkly (Apr. 20, 2023), https://www.computerweekly.com/news/365535576/Banks-dont-want-to-develop-fintech-in-house; Justin L. Mack, What Advisors Really Use Fintech 
For, and Why Ease of Use Matters Most: Wealthtech Weekly, Fin. Plan. 
(July 7, 2023), https://www.financial-planning.com/list/what-most-financial-advisors-are-using-fintech-for-wealthtech-weekly.
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3. Regulatory Baseline
    Investment advisers and broker-dealers are currently subject to 
obligations under Federal securities laws and regulations, and, in the 
case of broker-dealers, rules of SROs (in particular, FINRA),\273\ 
which are designed to promote conduct that, among other things, 
protects investors, including from certain conflicts of interest.\274\ 
The specific obligations are designed for the particular practices of 
investment advisers and broker-dealers and, accordingly, the regulatory 
baseline differs for each population.
---------------------------------------------------------------------------

    \273\ See supra note 59 and surrounding text.
    \274\ See supra note 60 and surrounding text.
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a. Investment Advisers
    The Advisers Act establishes a Federal fiduciary duty for 
investment advisers, which includes a duty to eliminate or disclose 
conflicts of interest.\275\ An adviser's fiduciary duty, which 
encompasses both a duty of loyalty and a duty of care,\276\ extends to 
the entire relationship between the adviser and client.\277\ 
Accordingly, an investment adviser (including one who uses PDA-like 
technologies) must, at all times, serve the best interest of its client 
and not subordinate its client's interest to its own. In other words, 
an investment adviser must not place its own interest ahead of its 
client's interests. As part of meeting this fiduciary duty, investment 
advisers must eliminate conflicts of interest--interests that might 
incline an investment adviser, consciously or unconsciously, to render 
advice that is not disinterested-- or at a minimum, make full and fair 
disclosure of the conflict of interest such that a client can provide 
informed consent to the conflict.\278\ Under this duty, investment 
advisers must also make full and fair disclosure of all material facts 
relating to the advisory relationship.\279\
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    \275\ SEC v. Capital Gains, 375 U.S. 180, 194 (1963) (``Capital 
Gains''). See also Investment Adviser Codes of Ethics, Investment 
Advisers Act Release No. 2256 (July 2, 2004) [69 FR 41695 (July 9, 
2004)]; Compliance Programs of Investment Companies and Investment 
Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003) 
[68 FR 74713 (Dec. 24, 2003)] (``Compliance Programs Release'').
    \276\ See Fiduciary Interpretation, supra note 8, at n.15 and 
accompanying text.
    \277\ See Fiduciary Interpretation, supra note 8, at section 
II.A.
    \278\ See Fiduciary Interpretation, supra note 8, at section 
II.C; Capital Gains, supra note 275, at 191-192 (describing a 
Congressional intent to ``eliminate, or at least to expose, all 
conflicts of interest which might incline an investment adviser--
consciously or unconsciously--to render advice which was not 
disinterested'').
    \279\ See Fiduciary Interpretation, supra note 8, at section 
II.C. See also Capital Gains, supra note 275 (``Failure to disclose 
material facts must be deemed fraud or deceit within its intended 
meaning.''); Amendments to Form ADV, supra note 236 (``as a 
fiduciary, an adviser has an ongoing obligation to inform its 
clients of any material information that could affect the advisory 
relationship''); General Instruction 3 to Part 2 of Form ADV 
(``Under federal and state law, you are a fiduciary and must make 
full disclosure to your clients of all material facts relating to 
the advisory relationship.'').
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    Advisers are required to provide clients with a Form ADV brochure, 
which details information about the adviser's business practices, fees, 
and certain conflicts of interest.\280\ The information provided must 
be sufficiently specific that a client is able to understand the 
investment adviser's business practices and conflicts of 
interests,\281\ and it is essential that the information be presented 
in a manner that clients are likely to read (if in writing) and 
understand.\282\ In addition, investment advisers (and broker-dealers) 
are required to provide ``retail investors'' with Form CRS, which 
explains fees, commissions, and other information that may be relevant 
when choosing a firm.\283\
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    \280\ See Amendments to Form ADV, supra note 236, at section I 
(``Since 1979, the Commission has required each adviser registered 
with us to deliver a written disclosure statement to clients 
pursuant to rule 204-3 under the Advisers Act.'') (citations 
omitted).
    \281\ See Amendments to Form ADV, supra note 236, at n.28.
    \282\ See Amendments to Form ADV, supra note 236, at section I. 
(``To allow clients and prospective clients to evaluate the risks 
associated with a particular investment adviser, its business 
practices, and its investment strategies, it is essential that 
clients and prospective clients have clear disclosure that they are 
likely to read and understand.''); see also Fiduciary 
Interpretation, supra note 8, at section I.C. (``In order for 
disclosure to be full and fair, it should be sufficiently specific 
so that a client is able to understand the material fact or conflict 
of interest and make an informed decision whether to provide 
consent.'') and at n.59.
    \283\ See Form CRS, General Instructions (``Under rule 17a-14 
under the Securities Exchange Act of 1934 and rule 204-5 under the 
Investment Advisers Act of 1940, broker-dealers registered under 
section 15 of the Exchange Act and investment advisers registered 
under section 203 of the Advisers Act are required to deliver to 
retail investors a relationship summary disclosing certain 
information about the firm.'').
---------------------------------------------------------------------------

    The duty of care requires, among other things, investment advisers 
to provide investment advice in the client's best interest, based on a 
reasonable understanding of the client's objectives. Investment 
advisers are subject more generally to the antifraud provisions, 
including section 206 of the Advisers Act,\284\ which prohibits fraud 
or deceit upon any client or prospective client; and 17 CFR 240.10b-5 
(``Exchange Act rule 10b-5''), which

[[Page 54003]]

makes it unlawful for any person to engage in fraud or deceit upon any 
person. Similarly, with respect to investors in pooled investment 
vehicles, rule 206(4)-8 under the Advisers Act makes it unlawful to 
make any untrue statement of a material fact, or to omit to state a 
material fact necessary to make the statements made, in light of the 
circumstances under which they were made, not misleading.\285\ It also 
makes it unlawful to engage in any act, practice, or course of business 
that is fraudulent, deceptive, or manipulative with respect to any 
investor or prospective investor in the pooled investment vehicle.\286\
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    \284\ 15 U.S.C. 80b-6.
    \285\ Prohibition of Fraud by Advisers to Certain Pooled 
Investment Vehicles, Investment Adviser Release No. 2628 (Aug. 3, 
2007) [72 FR 44756 (Aug. 9, 2007)] (``[Our] intent is to prohibit 
all fraud on investors in pools managed by investment advisers'').
    \286\ 17 CFR 275.206(4)-8.
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    In addition, the Advisers Act Compliance Rule requires advisers to 
adopt and implement written policies and procedures reasonably designed 
to prevent violations of the Act and the rules thereunder. In designing 
its policies and procedures pursuant to the Advisers Act Compliance 
Rule, each adviser should first identify conflicts and other compliance 
factors creating risk exposure for itself and its clients, and then 
design policies and procedures to address those risks.\287\ Moreover, 
rule 206(4)-1 under the Advisers Act prohibits advisers from 
disseminating any advertisement that violates any requirements of that 
rule, including making untrue statements of material fact or misleading 
omissions, and discussing with clients or investors in a private fund 
\288\ any potential benefits connected with or resulting from the 
investment adviser's services or methods of operation without providing 
fair and balanced treatment of any material risks or material 
limitations associated with the potential benefits.\289\ An investment 
adviser that uses PDA-like technology is subject to these obligations 
as applicable, and the fiduciary duty and the Advisers Act rules apply 
to an investment adviser's conduct for the entire scope of its 
relationship with its client, regardless of whether the adviser's 
conduct relies on the use of technology.\290\
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    \287\ Compliance Programs Release, supra note 275.
    \288\ As discussed above, in the case of investment advisers the 
proposed conflicts rules would apply with respect to an adviser's 
clients as well as investors in a private fund that an adviser 
manages. The Commission's existing regulatory regime under certain 
circumstances also applies to investors in a private fund. See, 
e.g., 17 CFR 275.206(4)-1, 275.206(4)-8, 240.10b-5.
    \289\ See 17 CFR 275.206(4)-1(a).
    \290\ See Fiduciary Interpretation, supra note 8, at section 
II.A; see, e.g., 2017 IM Guidance, supra note 115 (addressing among 
other things, presentation of disclosures, provision of suitable 
advice, and effective compliance programs).
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b. Broker-Dealers
    Broker-dealers are subject to comprehensive obligations under the 
Federal securities laws and SRO rules.\291\ For example, under the 
antifraud provisions of the Federal securities laws and SRO rules, 
broker-dealers have a duty to deal fairly with their customers and 
observe high standards of commercial honor and just and equitable 
principles of trade.\292\ As discussed below, these existing regulatory 
obligations apply generally, including to broker-dealers' current use 
of technology.
---------------------------------------------------------------------------

    \291\ These obligations cannot be waived or contracted away by 
customers. See Exchange Act section 29(a), 15 U.S.C. 78cc(a) (``Any 
condition, stipulation, or provision binding any person to waive 
compliance with any provision of [the Exchange Act] or any rule or 
regulation thereunder, or any rule of a [SRO], shall be void.'').
    \292\ See, e.g., Duker & Duker, Exchange Act Release No. 2350 
(Dec. 19, 1939) (Commission opinion) (``Inherent in the relationship 
between a dealer and his customer is the vital representation that 
the customer be dealt with fairly, and in accordance with the 
standards of the profession.''); see also SEC, Report of the Special 
Study of Securities Markets of the Securities and Exchange 
Commission, H.R. Doc. No. 95, at 238 (1st Sess. 1963) (``An 
obligation of fair dealing, based upon the general antifraud 
provisions of the Federal securities laws, rests upon the theory 
that even a dealer at arm's length impliedly represents when he 
hangs out his shingle that he will deal fairly with the public.''); 
FINRA Rule 2010 (Standards of Commercial Honor and Principles of 
Trade); FINRA Rule 2020 (Use of Manipulative, Deceptive, or Other 
Fraudulent Devices). See also FINRA Rule 2090 (Know Your Customer) 
requiring the broker-dealer to know essential facts concerning every 
customer and the authority of each person acting on behalf of the 
customer; FINRA Rule 4512 (Customer Account Information) requiring 
the broker-dealer to know, among other things, whether the customer 
is of legal age.
---------------------------------------------------------------------------

    Broker-dealers are subject to general and specific requirements 
aimed at addressing certain conflicts of interest, including 
requirements to eliminate,\293\ mitigate,\294\ or disclose certain 
conflicts of interest.\295\ Disclosure obligations related to conflicts 
of interest include disclosures before or at inception of the customer 
relationship.\296\ For example, broker-dealers (and investment 
advisers) are required to provide ``retail investors'' with Form CRS, 
which includes disclosures about, among other things, fees, commissions 
and firm- and financial professional-level conflicts of interest such 
as incentives created by the ways the firm makes money and

[[Page 54004]]

how it compensates its financial professionals.\297\
---------------------------------------------------------------------------

    \293\ See, e.g., 17 CFR 240.151-1(a)(2)(iii)(D) (requiring 
broker-dealers subject to Reg BI to ``[i]dentify and eliminate any 
sales contests, sales quotas, bonuses, and non-cash compensation 
that are based on the sales of specific securities or specific types 
of securities within a limited period of time''); 17 CFR 240.17a-14 
(requiring broker-dealers offering services to retail investors to 
disclose certain conflicts of interest in their Form CRS).
    \294\ See, e.g., 17 CFR 240.151-1(a)(2)(iii)(B) (requiring 
broker-dealers subject to Reg BI to ``[i]dentify and mitigate any 
conflicts of interest associated with such recommendations that 
create an incentive for a natural person who is an associated person 
of a broker or dealer to place the interest of the broker, dealer, 
or such natural person ahead of the interest of the retail 
customer''); FINRA Rule 3110(c)(3) (firm must have procedures to 
prevent the effectiveness of an internal inspection from being 
compromised due to conflicts of interest); FINRA Rule 3110(b)(6)(C) 
(supervisory personnel generally cannot supervise their own 
activities); FINRA Rule 3110(b)(6)(D) (firm must have procedures 
reasonably designed to prevent the required supervisory system from 
being compromised due to conflicts of interest). In addition, FINRA 
rules establish restrictions on the use of non-cash compensation in 
connection with the sale and distribution of mutual funds, variable 
annuities, direct participation program securities, public offerings 
of debt and equity securities, investment company securities, real 
estate investment trust programs, and the use of non-cash 
compensation to influence or reward employees of others. See FINRA 
Rules 2310, 2320, 2331, 2341, 5110 and 3220. These rules generally 
limit the manner in which members can pay or accept non-cash 
compensation and detail the types of non-cash compensation that are 
permissible.
    \295\ See supra note 68 and surrounding text explaining that a 
broker-dealer may be liable if it does not disclose ``material 
adverse facts of which it is aware.'' For example, when engaging in 
transactions directly with customers on a principal basis, a broker-
dealer violates Exchange Act Rule 10b-5 when it knowingly or 
recklessly sells a security to a customer at a price not reasonably 
related to the prevailing market price and charges excessive markups 
without disclosing the fact to the customer. See, e.g., Grandon v. 
Merrill Lynch, 147 F.3d 184, 189-90 (2d Cir. 1998). In addition, 
Exchange Act Rule 10b-10 requires a broker-dealer effecting 
transactions in securities (other than U.S. savings bonds or 
municipal securities) to provide written notice to the customer of 
certain information specific to the transaction at or before 
completion of the transaction, including the capacity in which the 
broker-dealer is acting (i.e., agent or principal) and any third-
party remuneration it has received or will receive). See also 17 CFR 
240.15c1-5 and 17 CFR 240.15c1-6, which require a broker-dealer to 
disclose in writing to the customer if it has any control, 
affiliation, or interest in a security it is offering or the issuer 
of such security. There are also specific, additional obligations 
that apply, for example, to recommendations by research analysts in 
research reports and to public appearances under Regulation Analyst 
Certification (AC). See, e.g., 17 CFR 242.500 et seq. Moreover, 17 
CFR 240.15l-1(a)(2)(i)(B) requires broker-dealers subject to Reg BI 
to fully and fairly ``disclose [a]ll material facts relating to 
conflicts of interest that are associated with the recommendation.'' 
Finally, SRO rules apply to specific situations, such as FINRA Rule 
2124 (Net Transactions with Customers); FINRA Rule 2262 (Disclosure 
of Control Relationship with Issuer), and FINRA Rule 2269 
(Disclosure of Participation or Interest in Primary or Secondary 
Distribution).
    \296\ The Form CRS relationship summary requires disclosure of 
the broker-dealer's services, fees, costs, conflicts of interest and 
disciplinary history. See 17 CFR 240.17a-14.
    \297\ See 17 CFR 240.17a-14; Form CRS, Instruction to Item 
3.B.(ii) of Form CRS (requiring firms to summarize the incentives 
created by certain ways in which they make money, including 
incentives crated by proprietary products); Form CRS, Instruction 
Item 3.C.(i)(requiring firms to summarize how their financial 
professionals are compensated, and the conflicts of interest those 
payments create).
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    Additionally, broker-dealers are liable under the antifraud 
provisions for failing to disclose material information to their 
customers when they have a duty to make such disclosure, including 
disclosures associated with the use of PDA-like technologies.\298\ 
Specifically, the antifraud provisions prohibit broker-dealers from 
making misstatements or misleading omissions of material facts, and 
fraudulent or manipulative acts and practices, in connection with the 
purchase or sale of securities.\299\
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    \298\ See Basic v. Levinson, 485 U.S. 224, 239 n.17 (1988). 
Generally, under the antifraud provisions, a broker-dealer's duty to 
disclose material information to its customer is based upon the 
scope of the relationship with the customer, which depends on the 
relevant facts and circumstances. See, e.g., Conway v. Icahn, 16 
F.3d 504, 510 (2d Cir. 1994) (``A broker, as agent, has a duty to 
use reasonable efforts to give its principal information relevant to 
the affairs that have been entrusted to it.'').
    \299\ See, e.g., Exchange Act Sections 10(b) and 15(c). Broker-
dealers may also be held liable under the Securities Act [of 1933] 
if ``in the offer or sale'' of any securities, the broker-dealer (1) 
employs any device, scheme, or artifice to defraud, (2) obtains 
money or property by means of any untrue statement of a material 
fact or any omission to state a material fact, or (3) engages in any 
practice which operates as a fraud or deceit upon the purchaser. See 
Securities Act of 1933 Section 17(a); see also Aaron v. SEC, 446 
U.S. 680 (1980) (holding that violations of Section 17(a)(1) require 
proof of scienter, but that violations of 17(a)(2) and (3) do not).
---------------------------------------------------------------------------

    Broker-dealers are subject to Reg BI when the broker-dealer, or an 
associated person of the broker-dealer, makes a recommendation of a 
securities transaction, or an investment strategy involving securities 
(including an account recommendation), to a retail customer. Reg BI 
requires that broker-dealers and associated persons act in the best 
interest of the retail customer at the time a recommendation is made, 
without placing the financial or other interest of the broker-dealer or 
an associated person making the recommendation ahead of the interests 
of the retail customer.\300\ This includes a requirement to have a 
reasonable basis to believe that a series of recommended transactions 
is not excessive and is in the retail customer's best interest when 
taken together in light of the retail customer's investment 
profile.\301\
---------------------------------------------------------------------------

    \300\ Reg BI Adopting Release, supra note 8, at n.549 and 
surrounding text.
    \301\ 17 CFR 240.15l-1(a)(2)(ii)(C); Reg BI Adopting Release, 
supra note 8.
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    Broker-dealers and, as applicable, their associated persons, 
satisfy the general obligation of Reg BI by complying with four 
specified component obligations: Disclosure, Care, Conflict of 
Interest, and Compliance.\302\ Reg BI, among other things, requires 
that broker-dealers address conflicts of interest by establishing, 
maintaining, and enforcing policies and procedures reasonably designed 
to identify and fully and fairly disclose material facts about 
conflicts of interest. In instances where the Commission has determined 
that disclosure is insufficient to reasonably address a conflict, the 
requirement is to mitigate or, in certain cases, eliminate the 
conflict.
---------------------------------------------------------------------------

    \302\ See Reg BI Adopting Release, supra note 8, at n.16 and 
surrounding text.
---------------------------------------------------------------------------

    Section 17(a) of the Securities Act of 1933 and Exchange Act rule 
10b-5 both prohibit fraud and deceit in the context of an offer, 
purchase, or sale of securities. These provisions generally prohibit 
fraudulent, deceptive, or manipulative practices and require issuers, 
broker-dealers, and advisers to be transparent and honest in their 
dealings with investors.\303\ In addition, FINRA rules govern broker-
dealer communications with the public--requiring them to reflect fair 
dealing, good faith, and to be fair and balanced--and prices for 
securities and services, which must be fair and reasonable given the 
relevant circumstances. Broker-dealers must also comply with FINRA's 
Rules of Fair Practice, which generally require broker-dealers to 
observe high standards of commercial honor and just and equitable 
principles of trade in conducting their business. Further, under the 
Federal securities laws and FINRA rules, prices for securities and 
broker-dealer compensation are required to be fair and reasonable, 
taking into consideration all relevant circumstances.\304\
---------------------------------------------------------------------------

    \303\ See supra notes 285 and 299.
    \304\ See, e.g., Exchange Act sections 10(b) and 15(c); FINRA 
Rules 2121 (Fair Prices and Commissions), 2122 (Charges for Services 
Performed), and 2341 (Investment Company Securities); see also FINRA 
Rule 3221 (Non-Cash Compensation).
---------------------------------------------------------------------------

    Under FINRA Rule 2210, broker-dealers' written (including 
electronic) communications with the public are subject to obligations 
pertaining to content, supervision, filing, and recordkeeping. FINRA 
has also adopted specialized requirements for communications with the 
public applicable to certain types of investments, including 
options.\305\ A broker-dealer's use of PDA-like technology is subject 
to these obligations as applicable. In addition, FINRA Rule 2214 
provides a limited exception to FINRA Rule 2210's prohibition on 
projected performance and allows broker-dealers to use ``investment 
analysis tools'' provided certain conditions are met.\306\ In 
particular, FINRA Rule 2214 requires broker-dealers using investment 
analysis tools to describe the criteria and methodology used, including 
the tool's limitations and key assumptions.\307\ Moreover, broker-
dealers using investment analysis tools pursuant to the rule must, 
among other things, describe the universe of investments considered in 
the analysis, explain how the tool determines which securities to 
select, and disclose if the tool favors certain securities.\308\
---------------------------------------------------------------------------

    \305\ See, e.g., FINRA Rule 2211 (Communications with the Public 
About Variable Life Insurance and Variable Annuities); FINRA Rule 
2212 (Use of Investment Companies Rankings in Retail 
Communications); FINRA Rule 2213 (Requirements for the Use of Bond 
Mutual Fund Volatility Ratings); FINRA Rule 2215 (Communications 
with the Public Regarding Security Futures); FINRA Rule 2216 
(Communications with the Public About Collateralized Mortgage 
Obligations (CMOs)); and FINRA Rule 2220 (Options Communications).
    \306\ See FINRA Rule 2214 (Requirements for the Use of 
Investment Analysis Tools). Investment analysis tools ``are 
interactive technological tools that produce simulations and 
statistical analyses that present the likelihood of various 
investment outcomes if particular investments are made or particular 
investment strategies or styles are undertaken.'' FINRA Regulatory 
Notice 16-41, Communications with the Public (Oct. 2016).
    \307\ See FINRA Rule 2214(c)(1).
    \308\ See FINRA Rule 2214(c)(3).
---------------------------------------------------------------------------

    Broker-dealers are also subject to supervision obligations, 
including the establishment of policies and procedures and systems for 
applying such policies and procedures reasonably designed to prevent 
and detect violations of, and to achieve compliance with, the Federal 
securities laws and regulations,\309\ as well as applicable SRO 
rules.\310\ Specifically, the Exchange Act authorizes the Commission to 
sanction a broker-dealer or any associated person that fails to 
reasonably supervise another person subject to the firm's or the 
person's supervision that commits a violation of the Federal securities 
laws.\311\ In addition to broker-dealers' supervisory obligations under 
the Exchange Act, FINRA Rule 3110 requires firms to establish and 
maintain a supervisory system for their business activities and to 
supervise the activities of their registered representatives, 
principals and other associated persons for purposes of achieving 
compliance with applicable securities laws and FINRA

[[Page 54005]]

rules. This supervisory system must include, among other things, the 
establishment, maintenance and enforcement of policies and procedures 
reasonably designed to achieve compliance with applicable securities 
laws and regulations and FINRA rules.\312\ FINRA rules also require 
policies and procedures to identify and manage conflicts of interest 
related to research analysts.\313\
---------------------------------------------------------------------------

    \309\ See section 15(b)(4)(E) of the Exchange Act.
    \310\ See FINRA Rule 3110 (Supervision).
    \311\ See section 15(b)(4)(E) of the Exchange Act.
    \312\ FINRA Rule 3110(a). In addition, FINRA Rule 3120 requires 
each member firm to (i) have a system of supervisory control 
policies and procedures to test and verify that the member's 
supervisory procedures are reasonably designed to achieve compliance 
with applicable securities laws and FINRA rules, and (ii) where 
necessary, amend or create additional supervisory procedures.
    \313\ FINRA Rule 2241 (Research Analysts and Research Reports).
---------------------------------------------------------------------------

    FINRA further requires that the chief executive officer (or 
equivalent officer) of each member firm must annually certify that it 
has in place processes which include testing and modifying the firm's 
policies and procedures to help ensure that they achieve compliance 
with applicable laws, regulations, and rules.\314\
---------------------------------------------------------------------------

    \314\ See supra note 212 (citing FINRA Rule 3130(b)).
---------------------------------------------------------------------------

c. Third-Party Service Providers
    Currently, third-party service providers who work with investment 
advisers or broker-dealers may not be required to address or disclose 
any conflicts of interest that may arise between the firm and the 
investor when firms use their services. Providers that develop covered 
technologies for use in the financial sector, however, are likely to be 
aware of the regulatory requirements governing the use of their 
products and may alter behavior as a result. Additionally, firms may 
contractually require service providers to identify potential sources 
of conflicts to aid firms' compliance with Commission and SRO 
rules.\315\
---------------------------------------------------------------------------

    \315\ See, e.g., the baseline discussion in Proposed Outsourcing 
Rule, supra note 124.
---------------------------------------------------------------------------

D. Benefits and Costs

    The proposed conflicts rules would impose several requirements on 
investment advisers and broker-dealers related to conflicts of interest 
associated with their use of a covered technology in investor 
interactions. Existing obligations already restrict firms from placing 
their interests ahead of customers, clients, or investors in certain 
contexts, such as when providing investment advice or recommendations, 
including as a result of conflicting interests related to their use of 
covered technologies. But the proposed conflicts rules would be 
beneficial because they would apply to a broader set of investor 
interactions and impose express requirements to evaluate and document 
certain conflicts of interest and to eliminate them or neutralize their 
effect. Because advisers and broker-dealers have different regulatory 
obligations currently, our discussion sometimes addresses the benefits 
and costs of the proposal to advisers separately from the benefits and 
costs of the proposal to broker-dealers.
    For advisers using covered technologies, the proposed rules may 
represent a shift in their obligations, as firms would be required to 
take proactive steps to address the conflicts of interest through 
elimination of conflicts or neutralization of the effect of the 
conflicts.\316\ For some technologies, though, advisers may be unable 
to rely on disclosure to address their existing conflicts obligations 
to the extent that the complex nature of the technologies and 
associated conflicts makes it difficult or impossible for the adviser 
to accurately determine whether it has designed a disclosure to put its 
clients in a position to be able to understand and provide informed 
consent to the conflicts; for these technologies, the proposed 
conflicts rules would specify the steps advisers must take with respect 
to a conflict of interest associated with the technology, but would not 
change advisers' underlying obligation to the extent that full and fair 
disclosure might be impossible.\317\
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    \316\ While full and fair disclosure of all material facts 
relating to the advisory relationship or of conflicts of interest 
and/or a client's informed consent could prevent the presence of 
those material facts or conflicts themselves from violating the 
adviser's fiduciary duty, such disclosure and/or consent do not 
themselves satisfy the adviser's duty to act in the client's best 
interest. See Fiduciary Interpretation, supra note 8, at n.58 and 
accompanying text.
    \317\ An adviser is already obligated to eliminate or mitigate 
conflicts of interest that cannot be fully and fairly disclosed. See 
Fiduciary Interpretation, supra note 8.
---------------------------------------------------------------------------

    Broker-dealers are governed by, among other requirements, the 
obligations of Reg BI, which requires that broker-dealers act in the 
best interest of the customer, when making a recommendation regarding 
securities to a retail customer. For recommendations, certain conflicts 
of interest at the firm level can be addressed through disclosure, and 
others which arise at the level of the firm's associated persons or 
resulting from limited menu options can be addressed through 
mitigation. In addition, under its care obligations, the broker or 
associated person must have a reasonable basis to believe its 
recommendations do not place its interests ahead of the retail 
customer's interests. However, a broker-dealer has no Regulation BI 
obligations for non-recommendation investor interactions, and instead 
is bound by underlying antifraud provisions and FINRA rules including 
the Rules of Fair Practice and those governing communications with the 
public.
    Firms that have any investor interactions using covered technology 
would also be required to adopt, implement, and (in the case of broker-
dealers) maintain specific policies and procedures with respect to the 
proposed conflicts rules' requirements to address conflicts, including 
with regard to the elimination or neutralization of conflicts of 
interest that place the firm's interests ahead of investors' interests. 
Firms generally are already required to have policies and procedures 
with respect to conflicts of interest, which may address conflicts 
associated with their use of technologies, including technologies that 
are highly complex and may pose serious risks of conflicts of 
interest.\318\ The proposed conflicts rules would provide minimum 
standards for what such policies must require, and would also seek to 
ensure all firms using covered technologies in connection with investor 
interactions.\319\ By requiring all such firms to have policies and 
procedures meeting these minimum standards, the proposed conflicts 
rules would likely represent a shift as compared to the baseline.
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    \318\ See Section III.C.3.
    \319\ This may include firms that generally meet the proposed 
requirements already, and, to varying degrees, firms that do not 
already meet the proposed requirements for a variety of possible 
reasons including that the firms may not completely understand the 
covered technology they use or may not recognize conflicts of 
interest or recognize when disclosure is inadequate.
---------------------------------------------------------------------------

    Many of the investor protection benefits of the proposed conflicts 
rules would be reduced to the extent that firms are already evaluating 
and eliminating, or neutralizing the effect of, conflicts associated 
with the use of covered technology. Benefits could also be reduced to 
the extent that firms already understand and are able to disclose the 
potential conflicts of interest associated with covered technology and 
investors already understand and respond to those disclosures such that 
disclosure adequately addresses the conflict of interest. On the other 
hand, for those covered technologies where it is difficult, or 
impossible, for firms to accurately determine whether they have 
designed their disclosures to put

[[Page 54006]]

investors in a position to be able to understand and provide informed 
consent to conflicts of interest due to the complex nature of the 
underlying technologies, the proposed conflicts rules could have 
comparatively greater benefits.\320\
---------------------------------------------------------------------------

    \320\ See, e.g., Bakos, et al., supra note 248; Agnieszka 
Kitkowska, Johan H[ouml]gberg & Erik W[auml]stlund, Online Terms and 
Conditions: Improving User Engagement, Awareness, and Satisfaction 
Through UI Design, CHI '22: Proceedings of the 2022 CHI Conference 
on Human Factors in Computing Systems, Article No. 624, at 1-22 
(Apr. 2022).
---------------------------------------------------------------------------

1. Benefits
    We preliminarily believe the primary benefit of the proposed 
conflicts rules and proposed recordkeeping amendments would stem from 
the requirement to eliminate, or neutralize the effect of, conflicts of 
interest that place the firm or associated person's interest ahead of 
investors' interests. This requirement could enhance investor 
protection by eliminating or neutralizing the effects of certain 
conflicts of interest, particularly in the context of the increasing 
scope and scale of investor interactions made possible by new 
technologies and by firms' increased ability to influence investor 
behavior in interactions that may not be viewed as constituting a 
recommendation or investment advice. The evaluation and identification 
requirements, the policies and procedures requirements, and the 
recordkeeping requirements primarily support the policy objectives of 
the elimination and neutralization requirement, and would serve to aid 
the examinations staff. However, we also note that the evaluation and 
identification requirements and the policies and procedures 
requirements might also yield ancillary benefits to investors, which we 
discuss below.
    In the following subsections, we discuss the specific requirements 
of the proposed conflicts rules and proposed recordkeeping amendments 
in detail. In the first part of this section, we discuss the benefits 
of the proposed conflicts requirements, and in the second part, we 
discuss the benefits of the policies and procedures requirements, and 
in the third, we discuss the benefits of the proposed recordkeeping 
amendments.
a. Proposed Conflicts Requirements
i. Evaluation and Identification
    The proposed conflicts rules would require that firms evaluate any 
use or potential use by the firm of a covered technology in any 
investor interaction, to identify any conflict of interest (including 
by testing each such covered technology prior to its implementation or 
material modification and periodically thereafter). The terms ``covered 
technology,'' ``investor interaction,'' and ``conflict of interest'' 
are defined broadly in the proposal. They would capture a wide variety 
of technology uses, interactions, and conflicts of interest, not all of 
which would be required to be eliminated or their effect to be 
neutralized. However, identifying and evaluating this broad set of 
activities would help firms to determine which conflicts of interest 
place a firm's interests ahead of investors' interests.
    This proposed requirement is important to help ensure that firms 
take proactive steps to identify conflicts of interest and evaluate 
their nature. Although firms already have obligations to address 
conflicts of interest, these do not necessarily apply equally to all 
forms of investor interaction, and the novelty and opacity of some 
covered technologies may leave firms unaware of conflicts of interest 
unless they take proactive steps to identify them.\321\
---------------------------------------------------------------------------

    \321\ See supra section I.B.4.a.
---------------------------------------------------------------------------

    In addition, the proposed conflicts rules would require firms to 
test periodically whether any covered technology is associated with a 
conflict of interest. The test would be required prior to 
implementation or material modification of the technology, and 
periodically thereafter. This requirement is important for the proposed 
conflicts rules because certain technologies might change or adapt over 
time. For example, algorithms that adapt the firm's recommendations 
based on the data it collects from its users might display behaviors 
that change over time, even though the underlying technology may not 
have been materially modified, which would need periodic testing to 
evaluate and to identify any new conflicts of interest that are 
generated.
ii. Determination, Elimination, and Neutralization
    The proposed conflicts rules would require the firm to determine 
whether an identified conflict of interest places the interest of the 
firm or an associated person ahead of the interests of the investor. As 
discussed below, these types of conflicts may require additional 
action. Requiring firms to make this determination is critical for the 
investor protection objectives of the proposed conflicts rules. This 
requirement would facilitate the elimination and neutralization 
requirements of the proposed conflicts rules.
    The proposed conflicts rules would impose requirements on firms to 
eliminate, or neutralize the effect of, conflicts of interest that 
place the firm's or an associated person's interest ahead of investors' 
interests (except for conflicts which exist solely due to seeking to 
open a new account).
    As discussed in section III.B, the scale and scope of investor 
interactions that are now possible with new technologies, and the scope 
and dynamic nature of the conflicts of interest that can be associated 
with the use of the technologies, present challenges for the use of 
disclosure. Disclosure of the full scope and dynamic nature of 
conflicts of interest that can be associated with the use of covered 
technologies can potentially be too broad and unspecific to be useful 
to a particular investor, or alternatively could entail too many 
disclosures to be useful to an investor. By requiring firms to 
eliminate, or neutralize, the effect of conflicts of interest that 
place the firm's or an associated person's interest ahead of investors' 
interest, the proposed conflicts rules could enhance investor 
protection and address some of the unique challenges posed by the use 
of covered technologies in investor interactions.
    Currently, broker-dealers' non-recommendation interactions with 
investors are not subject to conflict of interest requirements under 
Reg BI, and are instead bound by underlying antifraud provisions and 
FINRA rules including the Rules of Fair Practice, the requirement to 
observe just and equitable principles of trade, and rules governing 
communications with the public. Given the advances in covered 
technologies and DEPs, these non-recommendation interactions have the 
potential to influence investor behavior and place the firm's or 
associated person's interest ahead of investors' interests.
    The use of DEPs in retail investing can exacerbate the principal-
agent problem, by influencing investor behavior even if no 
recommendation is made. These platforms often utilize game-like 
features such as points, rewards, badges, leaderboards, interactive 
interfaces, push notifications, and other methods to encourage users to 
engage in trading activities. Some platforms use PDA technologies to 
target investors with notifications using detailed datasets, or use 
social proof and peer influence to influence investor behavior. These 
practices can take advantage of psychological biases and lead to 
impulsive, irrational investment decisions.
    While DEPs are perhaps the clearest and best understood case, 
behavioral

[[Page 54007]]

nudges embedded in interfaces, choices about data displays, the 
responses of chat bots, and other existing or future features may 
likewise influence investor behavior to their detriment and the benefit 
of covered firms. These uses of technology in investor interactions 
make it possible for firms to influence investor behaviors in a way 
that places the firm's or associated person's interest ahead of 
investors' interests.
    The addition of more information through disclosure may not 
mitigate the negative effects of the use of these DEPs on investing 
behavior. This is because the use of DEPs can rely on human 
psychological factors, rather than a lack of information. Given the 
rate of investor interactions and the ability of technology to learn 
investor preferences or behavior, disclosures may be too unspecific (if 
provided to cover the entire relationship) or too frequent (if provided 
with every interaction) to be useful to investors.\322\ Moreover, the 
features and design of covered technologies increase the risk through 
the constant presence enabled by automation, design practices which 
encourage habit formation, and the ability to collect data and 
individually and automatically tailor interventions to the proclivities 
of each investor. Elimination, or neutralization of the effect of, a 
conflict of interest could have greater investor protection benefits 
than disclosure to the extent that it could be difficult for a firm to 
accurately determine whether it has designed a disclosure that puts 
investors in a position to be able to understand the conflict of 
interest despite these psychological factors.
---------------------------------------------------------------------------

    \322\ See supra section III.B generally, and supra note 248 on 
disclosures. See also Reg BI Adopting Release, supra note 8, at 
III.B.4.c. (discussing the effectiveness and limitations of 
disclosure).
---------------------------------------------------------------------------

    Many of the covered investor interactions are already subject to 
existing requirements described in the baseline. These include the 
requirements of the investment adviser's fiduciary duty obligations 
toward clients; and the broker-dealer's Conflict of Interest Obligation 
under Reg BI for recommendation interactions. However, some 
interactions covered by the proposed conflicts rules would not 
constitute recommendations for the purposes of Reg BI, and might not 
receive the same investor protection benefits as recommendations. 
Relative to the baseline, the proposed conflicts rules would impose 
requirements specific to the use of covered technologies in investor 
interactions. The proposed conflicts rules' conflict of interest 
obligations would cover the entirety of investment advisers' 
interactions with investors, and for broker-dealers the entirety of 
their interactions with retail investors. This addition is motivated by 
the complex, opaque, and evolving nature of covered technologies and 
how firms use them to interact with investors, and the fact that they 
can operate on psychological rather than rational factors. In this 
context, for the use of certain complex and opaque technologies, the 
proposed conflicts rules could enhance investor protection and address 
some of the unique challenges posed by conflicts of interest in the use 
of covered technologies in investor interactions.
    The scope and frequency of investor interactions with new 
technologies and the complex, dynamic nature of those technologies may 
make it difficult for investors to understand or contextualize 
disclosures of conflicts of interest to the extent that the investors 
interact with the technologies, with interfaces or communications which 
feature outputs of the technologies, or with associated persons who 
make use of outputs of the technologies. For example, complex 
algorithms used in discretionary or non-discretionary robo-advising 
platforms could make it difficult for an investor to understand 
material facts or conflicts of interest and make an informed decision 
whether to consent or to allocate assets into or out of the platform. 
This could make it difficult for a firm to accurately determine whether 
it has designed a disclosure to put investors in a position to be able 
to understand and provide informed consent to the conflict of interest. 
Similarly, a chat-bot might provide investment advice based on a set of 
firm-investor conversations it has been trained to mimic using large 
language models. This advice may inherit any tendency to act on 
conflicts already present in conversations with firms or which were 
introduced by preferentially including conversations in the training 
data which resulted in the firm deriving greater benefits from the 
investor's resulting actions, for instance by overcoming investor 
resistance. In this situation where a conflict of interest may be 
exacerbated by the use of a covered technology, eliminating or 
neutralizing effects that place the firm's or associated person's 
interests ahead of investors' interests would better protect investors 
to the extent that investors may be unable to assess, or have 
difficulty in assessing, the significance of conflicts in the firm's 
interactions with them.
    By eliminating, or neutralizing the effect of, conflicts of 
interest that place the firm's or its associated persons' interest 
ahead of investors' interests, the proposed rules would protect 
investors from the negative effects of these conflicts. As mentioned in 
Section III.B, these conflicts of interest could lead firms to 
influence investors to use more services, increase transactions, or 
invest in risky investments that yield the firm or its associated 
persons higher profits than other products. To the extent that covered 
technologies present unique challenges to the current regulatory 
obligations of firms, eliminating, or neutralizing the effect of these 
conflicts would benefit investors by protecting them from these 
behaviors, and enabling them to make investment decisions that are in 
their best interests and aligned with their investment preferences, or 
improve the decisions made for the investor on their behalf.
    The scope and dynamic nature of covered technologies in investor 
interactions, and the scale at which they can reach investors, can also 
prompt bandwagon or herding effects in investor behavior that enhance 
volatility and liquidity risks.\323\ However, the firms that use 
covered technologies in investor interactions do not bear all of the 
costs of these risks. This negative externality creates a suboptimal 
incentive to allocate resources toward mitigating these risks. The 
proposed conflicts rules would require identification and evaluation of 
conflicts of interest, determination of which conflicts of interest 
place the firm's or an associated person's interest ahead of investors' 
interests, and elimination, or neutralization of the effect of, these 
conflicts, which could improve investor confidence in these 
technologies and prevent the loss of confidence in these technologies 
from spreading from one firm to another.\324\
---------------------------------------------------------------------------

    \323\ GameStop Report, supra note 250.
    \324\ Some broker-dealers use covered technologies and interact 
with both retail and non-retail investors. Even though non-retail 
investors are not defined by the proposed conflicts rule applicable 
to broker-dealers as investors, they might nevertheless indirectly 
benefit from the elimination or neutralization of conflicts of 
interest that place the firm's interest ahead of investors' 
interests.
---------------------------------------------------------------------------

b. Policies and Procedures
    Under the proposed conflicts rules, any firm that is subject to 
paragraph (b) of the proposed conflicts rules and that has any investor 
interactions using covered technology will have policies and procedures 
obligations. Specifically, investment advisers will be required to 
adopt and implement written policies and procedures reasonably designed 
to prevent violation of paragraph (b) of the proposed conflict rule, 
and broker-dealers will be required to adopt, implement, and maintain

[[Page 54008]]

written policies and procedures reasonably designed to achieve 
compliance with paragraph (b) of the proposed conflict rule.\325\ We do 
not believe, however, that there is a substantive difference between 
how firms would need to comply with each proposed conflict rule.\326\ 
The written policies and procedures must include the following 
features:
---------------------------------------------------------------------------

    \325\ See supra note 196.
    \326\ See id.
---------------------------------------------------------------------------

i. Written Description of Process Evaluating Use, Material Features and 
Conflicts of Interest of Covered Technology
    The policies and procedures must include: (i) a written description 
of the process for evaluating any use or reasonably foreseeable 
potential use of a covered technology in any investor interaction 
pursuant to paragraph (b) and (ii) a written description of any 
material features of, including any conflicts of interest associated 
with the use of, any covered technology used in any investor 
interaction prior to such covered technology's implementation or 
material modification, which must be updated periodically. These 
written policies and procedures help to ensure firms adopt effective 
implementation plans and help examinations staff assess whether firms 
have complied with paragraph (b) of the proposed conflicts rules. 
Requiring that firms describe the process they use to evaluate the use 
or potential use of covered technologies is important for helping 
ensure that firms understand and document how their technology will be 
used or potentially used, and whether it involves investor interaction. 
Similarly, requiring a description of the material features of, and any 
conflicts of interest associated with the use of, the covered 
technology is important for helping ensure firms understand and 
document how their technology functions, and the conflicts of interest 
associated with their use. Requiring that the description of material 
features and conflicts of interest be in place before implementation or 
material modification would help ensure that firms consider covered 
technologies and identify and address conflicts of interest before 
investors could be harmed.
    In addition, these written descriptions would be required to be 
updated periodically. Given that the effects of technologies can change 
materially as they are further developed or used in new contexts, this 
requirement would help ensure that the information remains current and 
the firm performs the necessary evaluation before harmful changes can 
proliferate.
ii. Written Description Determining Whether and How To Eliminate, or 
Neutralize the Effect of, Any Conflict of Interest
    The proposed conflicts rules would require that the policies and 
procedures include a written description of the process for determining 
whether and how to eliminate, or neutralize the effect of, any 
conflicts of interest determined pursuant to paragraph (b)(2) of the 
proposed conflicts rules to place the interest of the firm or an 
associated person ahead of the interests of the investor. The proposed 
conflicts rules give firms considerable latitude to determine how to 
approach the elimination, or neutralization of the effect of, conflicts 
of interest. While this is necessary to help the proposed conflicts 
rules apply to a wide variety of business models and technologies, it 
also raises the risk that firms could adopt approaches that are 
inadequate to prevent them from placing their interests ahead of those 
of investors. This requirement would promote the development of 
considered and documented policies and procedures for determining 
whether and how to eliminate, or neutralize the effect of, any conflict 
of interest, instead of doing so on an ad hoc basis. Having a 
documented policy and procedure could also aid the training of the 
firm's compliance staff, and aid examiners and the firm when assessing 
a firm's compliance with the rules.
iii. Review of Written Description
    The proposed conflicts rules would also require that the policies 
and procedures include a review of the written description required 
pursuant to paragraph (c)(1) of the proposed conflicts rules. The 
periodic review element requires a firm to consider whether any changes 
in the business activities, any changes in the use of technology 
generally, any issues that arose with the technologies during the 
previous year, and any changes in applicable law might suggest that 
certain covered technologies are of a different or greater risk than 
the firm had previously understood. Based on this periodic review, 
firms might be better able to determine whether changes are necessary 
in their approach to identification, determination, and elimination or 
neutralization of conflicts of interest and whether material changes to 
the use of technology are reflected by the written description. The 
regular review of the written description can help to ensure that the 
investor protection benefits of the proposed rules do not diminish 
after a covered technology is initially implemented, and improve 
investor confidence that firms have updated policies and procedures to 
identify, determine, and eliminate or neutralize certain conflicts of 
interest.
c. Proposed Recordkeeping Amendments
    The proposed recordkeeping amendments would require firms to make 
and keep several types of records. First, firms would be required to 
maintain written documentation of the evaluation conducted pursuant to 
paragraph (b)(1) of the proposed conflicts rules, including a list or 
other record of all covered technologies used by the firm in investor 
interactions, as well as documentation describing any testing of the 
covered technology in accordance with paragraph (b)(1) of the proposed 
conflicts rules. Second, firms would be required to maintain written 
documentation of each determination made pursuant to paragraph (b)(2) 
of the proposed conflicts rules, including the rationale for such 
determination. Third, firms would be required to maintain written 
documentation of each elimination or neutralization made pursuant to 
paragraph (b)(3) of the proposed conflicts rules. Fourth, firms would 
be required to maintain written policies and procedures, including 
written descriptions, prepared in accordance with paragraph (c) of the 
proposed conflicts rules. Fifth, firms would be required to maintain a 
record of the disclosures provided to investors regarding the firm's 
use of covered technologies. And sixth, firms would be required to 
maintain records of each instance in which a covered technology was 
altered, overridden, or disabled, the reason for such action, and the 
date thereof, including records of all instances where an investor 
requested that a covered technology be altered or restricted in any 
manner.
    The proposed recordkeeping amendments would help ensure that a 
record of a firm's use of covered technology is maintained and 
preserved for an appropriate period of time consistent with the firm's 
other existing recordkeeping obligations. The proposed recordkeeping 
amendments would also help facilitate the Commission's oversight and 
enforcement capabilities by creating a record that the staff could use 
to assess compliance with the requirements of the proposed conflicts 
rules, and help ensure that the investor protection benefits of the 
proposed rules are realized.

[[Page 54009]]

2. Costs
    This section discusses two types of costs. We discuss the direct 
costs of the requirements of the proposed conflicts rules and proposed 
recordkeeping amendments and provide quantitative estimates of the 
costs of each provision. We then discuss the indirect costs of the 
proposed conflicts rules and proposed recordkeeping amendments, such as 
the potential impact on the use of technology and innovation.
a. Direct Costs
i. Proposed Conflicts Rules--Eliminate, or Neutralize the Effect of, 
Conflicts of Interest
    We preliminarily anticipate that firms might need to hire dedicated 
personnel or dedicate the time of existing personnel to comply with the 
requirements of the proposed conflicts rules. The cost of identifying 
the presence of conflicts present in technology and determining if they 
lead to interactions in which the interests of the firm are placed 
ahead of those of the investor may vary greatly. Firms which have more 
conflicts of interest, or have conflicts more deeply embedded in the 
covered technologies they use, would likely bear greater costs than 
those that do not. Similarly, a firm's costs are likely to vary 
depending on the nature of covered technology they use in investor 
interactions and the extent of that use. For tools and processes which 
are relatively transparent, a code review may suffice. For technology 
where the process of generating outputs from a given set of inputs is 
opaque, as is often the case with the product of machine learning, it 
may be necessary to develop a testing system or engage with an 
independent third party with a system to identify conflicts of interest 
in all reasonably foreseeable uses of the technology. Such a system 
might record the outputs of the technology, measure the prospective or 
achieved outcomes for the investor and the firm, and compare them to 
those achieved by alternative specifications of the technology. To the 
extent that training models often require substantial computational 
resources and human feedback during the training process, testing of 
opaque systems could entail significant costs, which could entail the 
need to either hire dedicated personnel, or allocate the time of 
existing personnel.
    The direct costs to eliminate, or neutralize the effect of, 
conflicts of interest in covered technologies would depend strongly on 
the technology used, the firm's business model, the nature of the 
conflicts, and the nature and extent of the interactions. For 
traditional optimizing methods or functions where a conflict is 
explicitly included in the model, the cost of excising the offending 
features may be trivial. In contrast, for methods which are opaque or 
where the technology optimizes over factors other than the firm's or an 
associated person's interest, but which may correlate with the firm's 
or associated person's interest, a more substantial and thus costly 
testing regime might be necessary. For some methods, such as NLP 
methods trained to replicate employee responses to investor 
communications, additional human input into the training process may be 
necessary to identify responses which potentially reflect conflicts of 
interest. This training input could be substantial and may need to be 
repeated as market institutions and conditions change, particularly if 
such changes are such that the data set on which the technology was 
trained does not adequately reflect new conditions. In some cases, 
firms could opt to eliminate conflicts directly, such as by changing 
their fee structure or other revenue generation models, rather than 
eliminating or neutralizing the consideration of the conflicts within 
their covered technologies.
    We provide two sets of cost estimates in Table 1, to reflect the 
extent to which the costs can vary depending on the complexity of the 
firm's use of covered technology. Firms with complex covered 
technologies, such as machine learning or NLP algorithms, or those that 
process large datasets, might require more resources to comply with the 
requirements associated with eliminating, or neutralizing the effect 
of, conflicts of interest where the firm's or an associated person's 
interest is placed ahead of the interests of investors. Firms with 
simple technologies, such as spreadsheets or basic algorithms, would 
likely require fewer resources. In addition, firms might have business 
models of varying complexity, or with varying degrees of investor 
interaction, which could affect the costs they would bear. The 
Commission seeks comment or data on the costs of requirements of the 
proposed rules that could improve these estimates.

 Table 2--Direct Costs of Proposed Rules Requirements To Evaluate, Identify, Determine, and Eliminate, or Neutralize the Effect of, Certain Conflicts of
                                                                        Interest
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                            Simple covered technology firm                      Complex covered technology firm
                                                 -------------------------------------------------------------------------------------------------------
           Proposed rules requirement               Initial      Initial       Annual                   Initial      Initial       Annual
                                                     hours         cost        hours     Annual cost     hours         cost        hours     Annual cost
--------------------------------------------------------------------------------------------------------------------------------------------------------
Evaluate Use of Covered Technology and Identify            10       $4,460            5       $2,230          100      $44,600           50      $22,300
 Conflicts of Interest..........................
Determine Which Conflicts of Interest Require               5        2,230          2.5        1,115           50       22,300           25       11,150
 Elimination or Neutralization..................
Eliminate or Neutralize Effects of Certain                 10        4,460            5        2,230          200       89,200          100       44,600
 Conflicts of Interest..........................
                                                 -------------------------------------------------------------------------------------------------------
    Sub-Total Burden............................           25       11,150         12.5        5,575          350      156,100          175       78,050
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total Number of Firms...........................                        16,182
                                                                         1,798
                                                 -------------------------------------------------------------------------------------------------------
    Total Aggregate Burden......................      404,550  180,429,300      202,275   90,214,650      629,300  280,667,800      314,650  140,333,900
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Commission staff estimates, based on blended rate for a senior portfolio manager ($383), senior operations manager ($425), compliance attorney
  ($425), assistant general counsel ($523), senior programmer ($386), and computer operations department manager ($513), rounded to the nearest dollar.
\2\ Based on the estimates in section IV.B, we preliminarily estimate that 17,719 firms will bear the cost of a Simple Covered Technology firm,
  consisting of 15,402 investment advisers and 2,317 broker-dealers. We preliminarily estimate that 1,798 firms will bear the cost of Complex Covered
  Technology firm, consisting of 1,540 investment advisers and 258 broker-dealers.


[[Page 54010]]

ii. Proposed Conflicts Rules--Policies and Procedures
    The policies and procedures portion of the proposed conflicts rules 
would require investment advisers to adopt and implement written 
policies and procedures reasonably designed to prevent violations of 
paragraph (b) of the proposed conflicts rules, and broker-dealers to 
adopt, implement, and maintain written policies and procedures 
reasonably designed to achieve compliance with paragraph (b) of the 
proposed conflicts rules.\327\ These policies and procedures would need 
to include a written description of any material features of, any 
conflicts of interest associated with the use of, and any covered 
technology used in any investor interaction prior to such covered 
technology's implementation or material modification. In addition, the 
policies and procedures must require that the adequacy of the policies 
and procedures and written description of material features be reviewed 
regularly. The policies and procedures also must require a written 
description of the process by which the firm determines whether and how 
to eliminate, or neutralize the effect of, any conflicts of interest 
determined pursuant to paragraph (b)(2) of the proposed rules to place 
the interest of the firm or an associated person ahead of the interests 
of the investor.
---------------------------------------------------------------------------

    \327\ See supra note 196.
---------------------------------------------------------------------------

    We note that the Commission has provided certain estimates for 
purposes of compliance with the Paperwork Reduction Act of 1995 
(``PRA''), as further discussed in Section IV below. Those estimates, 
while useful to understanding the collection of information burden 
associated with the final rules, do not purport to reflect the full 
economic costs associated with making the required disclosures. The PRA 
cost estimates are: (1) for the adoption and implementation of policies 
and procedures, an annual cost of $14,610 for the firm; (2) for the 
requirement to create and maintain a written description of the covered 
technology, an annual cost of $18,955 on firms and (3) and for the 
annual review requirement, an ongoing annual cost of $2,230.\328\
---------------------------------------------------------------------------

    \328\ See infra section IV.B.
---------------------------------------------------------------------------

iii. Proposed Recordkeeping Amendments
    As discussed above, the proposed recordkeeping amendments would 
require firms to maintain information about the firm's use of covered 
technology in investor interactions, and any associated conflicts of 
interest. This includes written documentation of the evaluation 
conducted pursuant to paragraph (b)(1) of the proposed conflicts rules, 
including a list or other record of all covered technologies used by 
the firm in investor interactions, as well as documentation describing 
any testing of the covered technology in accordance with paragraph 
(b)(1) of the proposed conflicts rules; written documentation of each 
determination made pursuant to paragraph (b)(2) of the proposed 
conflicts rules, including the rationale for such determination; 
written documentation of each elimination or neutralization made 
pursuant to paragraph (b)(3) of the proposed conflicts rules; written 
policies and procedures, including written descriptions, prepared in 
accordance with paragraph (c) of the proposed conflicts rules; a record 
of the disclosures provided to investors regarding the firm's use of 
covered technologies; and records of each instance in which a covered 
technology was altered, overridden, or disabled, the reason for such 
action, and the date thereof, as well as records of all instances where 
an investor requested that a covered technology be altered or 
restricted in any manner. While these requirements aid the Commission 
in assessing the extent to which firms have complied with the other 
requirements of the proposed conflicts rules, we expect these 
requirements to impose costs on firms that will have to create and 
maintain these records. As further discussed in Section IV below, the 
PRA estimates that firms would face an ongoing annual cost of $7,622 
from the recordkeeping requirements, but would not face initial costs.
b. Indirect Costs
    In the previous section, we discussed the direct costs of complying 
with the requirements of the proposed conflicts rules and proposed 
recordkeeping amendments. However, firms might not bear the ultimate 
burden of these costs. Firms might pass the cost of the requirements 
along to investors through higher fees, commissions, or other methods. 
It is difficult to estimate or quantify how much of these costs firms 
will end up paying themselves instead of passing on to investors, and 
this depends on how sensitive investors are to changes in the cost of 
the service provided by the firm, and how sensitive the firm is to 
changes in the costs of providing that service.\329\
---------------------------------------------------------------------------

    \329\ Arnold C. Harberger, The Incidence of the Corporation 
Income Tax, 70 J. Pol. Econ. 215-240 (1962). The ultimate cost 
burden will be determined by the relative elasticity of the demand 
and supply curves for the service provided by the technology. 
Although this paper refers to the incidence of the tax burden, it is 
mechanically identical to determining which entities will bear the 
ultimate cost of the proposed rules.
---------------------------------------------------------------------------

    The proposed requirements to eliminate, or neutralize the effect 
of, conflicts of interest which place the firm's or an associated 
person's interest ahead of the interests of investors can impose 
additional costs on the firm. Eliminating conflicts or neutralizing 
their effect can cause firms to lose the revenue that might have been 
generated by conflicts associated with uses of the technology, where 
the firm complied with and made adequate disclosure under all 
preexisting rules regarding conflicts of interest. In addition, 
eliminating conflicts or neutralizing their effect could also make 
technologies less efficient, as firms might alter these technologies 
with internal checks and safeguards to comply with the rules. For 
example, firms might add testing code to the technology or guard rails 
to the development process that could make the technology or its 
development less efficient and impose costs on the firm.
    The overall costs, including recordkeeping costs, of the proposed 
conflicts rules and proposed recordkeeping amendments could also cause 
some firms to avoid using certain covered technologies in investor 
interactions, even if the technologies did not create any conflicts of 
interest. This might happen if the costs of complying with the proposed 
rules and amendments exceed the revenue that can be gained and/or costs 
that can be saved by using the technology. For example, a firm might 
opt not to use an automated investment advice technology because of the 
costs associated with complying with the proposed rules and amendments. 
In these types of situations, firms would lose the potential revenues 
that these technologies could have generated, and investors would lose 
the potential benefits of the use of these technologies. In addition, 
in the absence of these technologies, firms might raise the costs of 
their services, thus increasing the costs to investors.
    In addition, to the extent that the firm's existing obligations do 
not require the elimination, neutralization, or disclosure of covered 
conflicts of interest, the requirement to identify conflicts of 
interest in a technology could dissuade firms from using certain 
technologies when it is too difficult or costly to adequately evaluate 
the use of the covered technology, identify a conflict of interest, or 
determine whether they place the firm's or an

[[Page 54011]]

associated person's interest ahead of an investor's. Some types of AI 
and machine learning, or a marketing algorithm with a large dataset, 
could be costly to test or difficult for the firm to assess. In these 
situations, investors would lose the potential benefit of these types 
of technologies, which could in theory have no conflict of interest, 
but firms might have no practical or financially viable way to 
demonstrate that there was not a conflict of interest or that any such 
conflict did not result in actions placing the firm's or an associated 
person's interest ahead of an investor's interest. Similarly, there may 
be technologies that do create conflicts that must be eliminated or 
their effect neutralized, but that also benefit investors if firms 
address those conflicts. Investors would lose the benefit of such 
technologies if firms determine that the process of eliminating, or 
neutralizing the effect of, conflicts is too difficult, costly, or 
uncertain to succeed.
    Broker-dealers that use covered technologies and interact with both 
retail and non-retail investors might pass along some of the cost 
burden of the rules onto both retail and non-retail investors. Even 
though non-retail investors are not defined by the proposed rules as 
investors, they might nevertheless indirectly bear some of the costs of 
the proposed conflicts rule. In addition, non-retail investors might 
also be adversely affected to the extent that broker-dealers alter the 
use of their covered technologies to respond to conflicts of interest 
with retail investors.
    We anticipate that firms may rely on third-party providers to 
develop covered technologies. Even if these third-party providers are 
not regulated entities under the proposed conflicts rules, they could 
consider the proposed rules when designing their products and processes 
for firms that must meet the proposed conflicts rules' requirements, 
either independently or at the request of firms covered by the proposed 
conflicts rules. To the extent that the requirements of the proposed 
conflicts rules result in more costly development, testing, and 
documentation, these third-party providers may incur costs. In 
addition, competition between third-party providers might drive down 
the costs of compliance for firms. Firms with bargaining power might 
also seek to pass on certain compliance costs to third-party providers, 
for instance by seeking assurances that the covered technology provided 
by the third party would not generate conflicts of interest between the 
firm and the investor. In this context, competition between third-party 
providers might pass some or all of these costs on to firms in product 
prices and service fees, and firms in turn may pass some or all of 
these costs on to investors. The proportion of costs that are passed 
through each entity will depend on competition among providers and 
firms, the price sensitivity of investors, and the perceived value of 
the various covered technologies.
    The requirements to test and document conflicts related to the use 
of technologies would not only add costs to firms that use covered 
technologies in investor interaction, they could also slow down the 
rate at which firms update existing or develop or adopt new 
technologies. The time needed to review and document changes to the 
technology could incentivize firms to reduce the frequency of 
technological updates, or slow the overall rate of updates, which could 
harm both the firm and investors. These delays and associated monetary 
costs could reduce the quality or increase the cost of the technology 
or service for investors, and could reduce the revenues of the firms.

E. Effects on Efficiency, Competition, and Capital Formation

1. Efficiency
    The proposed conflicts rules would positively impact efficiency by 
providing investors with greater confidence regarding the conflicts of 
interest associated with the use of covered technologies that they 
interact with or whose outputs help determine the form or content of 
investor interactions. Investors would not have to expend costly 
efforts (including in terms of the opportunity cost of time) on 
understanding the effects of complex and opaque technologies, and the 
disclosures thereof, that the firms use in their interactions with 
investors when they can instead rely on conflicts which place the 
interest of the firm or an associated person ahead of investors' 
interests to have been eliminated or their effect to have been 
neutralized. Further, myriad of investors would not have to duplicate 
these costly efforts that they each may otherwise independently expend. 
In this context, the proposed conflicts rules would enhance economic 
efficiency by improving the efficiency of portfolio allocations, or by 
enabling the resources thereby saved to be allocated to more productive 
economic outcomes. In addition, reducing the costly effort that 
investors must undertake to understand covered technologies and their 
associated disclosures by eliminating, or neutralizing the effect of, 
conflicts of interest that place the firm's or an associated person's 
interest ahead of an investor's could increase participation in 
financial markets and improve efficiency.
    The proposed conflicts rules could negatively affect efficiency by 
impeding the use of technology in several ways. First, the compliance 
costs of the proposed conflicts rules could dissuade some firms from 
using covered technologies in investor interactions. For example, a 
firm might decide that using a chatbot technology that provided 
investment advice would be too costly because of the obligations 
imposed by these rules, and instead opt for human alternatives. To the 
extent that the chatbot technology was more efficient at providing 
support to investors, the efficiency of the firm's ability to provide 
advice would be decreased. Second, certain types of technology might be 
too difficult or costly to evaluate, or to modify to comply with the 
rules, and firms could avoid using these technologies. For example, a 
firm might decide that a covered technology was developed based on data 
that are too complex to evaluate, or to identify all conflicts of 
interest, and therefore the firm might have difficulty complying with 
the proposed conflicts rules. In these cases, firms and investors would 
not enjoy any of the efficiency gains that the covered technology might 
have yielded, or have yielded if already implemented. Third, the costs 
and requirements could slow down the frequency or overall rate of 
technological updates to existing covered technologies and exploration 
of new covered technologies, as well as make the technology itself less 
efficient. For example, firms might need to add guard rails to the 
development process, or additional layers of review of any potential 
changes to the technology. Not only could this harm the firm and 
investors due to, for example, foregone cost savings, lack of tailoring 
of recommendations to individual investors, or unimplemented user 
experience improvements, but it also could slow down technological 
innovation and progress more broadly.\330\ However, to the extent rapid 
development and implementation of such innovations result in the 
release of flawed or otherwise harmful products into the marketplace, 
efficiency may be improved.\331\
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    \330\ These losses in efficiency could also adversely affect 
non-retail investors that interact with broker-dealer covered 
technologies that also interact with retail investors.
    \331\ We do not expect the proposed recordkeeping amendments to 
generate significant effects on efficiency. The proposed 
recordkeeping amendments generally would serve to support the 
implementation of the proposed conflicts rules.

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[[Page 54012]]

2. Competition
    Eliminating, or neutralizing the effect of, conflicts of interest 
would have two principal competition-related effects. First, investors 
could have greater confidence in interactions with firms using covered 
technologies, and could therefore be more likely to participate in 
financial markets. Second, when evaluating firms, investors would 
likely put additional weight on key factors such as advisory, 
management, or brokerage fees and execution quality, which also 
directly impact market efficiency, thereby increasing the extent to 
which firms compete on these factors. These two effects could 
positively affect competition between firms and result in lower fees 
and higher service quality for investors.
    The proposed conflicts rules could also result in costs that could 
act as barriers to entry or create economies of scale, potentially 
making it challenging for smaller firms to compete with larger firms 
utilizing covered technologies--as firms continue to increasingly rely 
on covered technologies for investor interactions.\332\ Ensuring 
compliance with the proposed conflicts rules would require additional 
resources and expertise, which could become a significant barrier to 
entry, potentially hindering smaller firms from entering the market or 
adopting new technologies. Moreover, larger firms with a larger client 
or customer base may have a competitive advantage over smaller firms 
because they may be better able to spread the (fixed) cost of the 
proposed conflicts rules across their clients, or more effectively 
negotiate with third party providers to obtain compliant technology 
externally. Smaller firms subject to the proposed conflicts rules could 
also face a competitive disadvantage compared to larger firms when 
negotiating with technology companies to build software that complies 
with the proposed conflicts rules.
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    \332\ Similarly, some broker-dealers with a small retail 
investor business line and a larger non-retail investor business 
line could decide to cut back on serving retail investors to avoid 
incurring the compliance costs. This could increase market 
concentration among broker-dealers that service retail investors.
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    These competitive effects might be mitigated to the extent that 
firms are using technologies licensed from third party providers. Third 
party technology providers might compete with each other to lower the 
cost of compliance, compared to the case where firms bore the costs of 
compliance internally. Moreover, to the extent that firms have 
bargaining power over third party providers, they may be able to shift 
some of the compliance burden onto these providers. To the extent that 
third party providers develop the ability to lower compliance costs 
through competition, smaller firms may also experience reduced 
compliance costs.\333\
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    \333\ We do not expect the proposed recordkeeping amendments to 
generate significant effects on competition. The proposed 
recordkeeping amendments generally would serve to support the 
implementation of the proposed conflicts rules.
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3. Capital Formation
    The impact of the proposed conflicts rules on capital formation 
would be influenced by a number of factors. On the one hand, the 
elimination or neutralization of the effects of certain harmful 
conflicts of interest in firms' use of covered technologies could 
enhance capital formation if the quality of services is improved, or 
investment performance or execution quality is improved, and investors 
trust these technologies more and invest more as a result. On the other 
hand, the costs associated with the proposed conflicts rules could have 
the opposite effect. If these costs result in increased fees for 
investors or deter firms from using covered technologies in investor 
interaction, then capital formation could be hindered. This could be 
particularly problematic for smaller firms who may struggle to absorb 
these additional costs. In addition, to the extent that the costs of 
the technology are too high and firms avoid using certain covered 
technologies that benefit investors, capital formation could be 
hindered.\334\
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    \334\ We do not expect the proposed recordkeeping amendments to 
generate significant effects on capital formation. The proposed 
recordkeeping amendments generally serve to support the 
implementation of the proposed conflicts rules.
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F. Reasonable Alternatives

    In formulating our proposal, we have considered various 
alternatives. Those alternatives are discussed below and we have also 
requested comments on certain of these alternatives.
1. Expressly Permit, or Require, the Use of Independent Third-Party 
Analyses
    This alternative would expressly state that firms may utilize 
independent third parties to assess compliance with elements of the 
proposed conflicts rules.\335\ A variation on this alternative would 
require the use of independent third-party assessments. Allowing or 
requiring the use of independent third parties to carry out and assess 
compliance could help ensure that identification and evaluation of 
conflicts of interest, the determination of which conflicts of interest 
place the firm's or an associated person's interest ahead of 
investors', and the elimination, or neutralization of the effect of, 
the conflict of interest are done in an objective and unbiased manner. 
In addition, the use of independent third parties could reduce the 
costs of complying with the associated proposed conflicts rules and 
eliminate or reduce the need for firms to maintain dedicated staff. 
Independent third-party firms might have more expertise or be more 
efficient than individual firms, especially smaller firms, at analyzing 
the function and the effects of covered technologies, especially 
technologies licensed from third party service providers.
---------------------------------------------------------------------------

    \335\ The proposed conflicts rules do not prohibit such third-
party analyses.
---------------------------------------------------------------------------

    However, this alternative could undermine the investor protection 
benefits of the proposed conflicts rules and proposed recordkeeping 
amendments if independent third parties are less efficient at 
identifying and evaluating conflicts of interest in the use of covered 
technologies in investor interactions, because they might not have the 
same level of information about a firm's business and investors. In 
addition, competition between independent third parties for the 
business of firms could result in a ``race to the bottom'' of the 
quality of compliance assessments.
2. Require That Senior Firm Personnel and/or Specific Technology 
Subject-Matter Experts Participate in the Process of Adopting and 
Implementing These Policies and Procedures
    This alternative would add a requirement to the proposed conflicts 
rules that senior firm personnel and/or specific technology subject-
matter experts participate in the process of adopting and implementing 
these policies and procedures. In addition, these senior firm personnel 
and/or specific technology subject-matter experts would be required to 
certify that such policies and procedures that the firm adopts and 
implements (and, in the case of broker-dealers, maintains) are in 
compliance with the requirements of this paragraph (c) of the proposed 
conflicts rules. Requiring the use of these personnel could potentially 
enhance the effectiveness of the policies and procedures that firms 
create, which could improve a firm's ability to evaluate and identify 
conflicts of interest, and eliminate or neutralize conflicts of 
interest that place the firm's interest ahead of the investors. To the 
extent that such personnel are not necessary to satisfy the policies 
and

[[Page 54013]]

procedures requirements of the proposed conflicts rules, the 
requirement to use these personnel could impose additional costs on 
firms, which would have to hire additional personnel to satisfy the 
requirement, divert the labor of existing personnel, or engage with a 
third-party service provider. In addition, the requirement that these 
personnel provide a certification for the policies and procedures would 
also add additional costs not present in the proposal on firm, and 
create potential barriers to entry for small firms.
3. Provide an Exclusion for Technologies That Consider Large Datasets 
Where Firms Have No Reason To Believe the Dataset Favors the Interests 
of the Firm From the Identification, Evaluation, and Testing 
Requirements
    This alternative would provide an exclusion from all of the 
proposed requirements for technologies that consider large datasets, 
where firms have no reason to believe the dataset favors the interests 
of the firm. An example of this type of technology might include a 
chatbot technology that is trained on large portions of the internet. 
To the extent that the training dataset is not chosen or created in a 
biased manner, a firm could reasonably believe that it does not 
consider the interest of the firm, and yet the firm could have 
difficulty complying with the proposed conflicts rules' requirements to 
identify conflicts of interest generated by the use of the technology.
    An exclusion for this type of technology use could reduce the costs 
imposed on the firms that use these technologies, or make certain 
covered technologies cost-effective to use. However, the exclusion 
could also undermine the investor protection goals of the proposed 
conflicts rules by lowering the standards placed on firms' use of 
covered technologies in investor interactions. Even though firms likely 
would need to conduct due diligence in order to establish their 
reasonable belief, and update it regularly, this alternative could 
result in a regime where firms only reasonably believe that their 
technologies do not have conflicts of interest, rather than one where 
firms have tested for conflicts of interest in their covered 
technologies. In addition, this alternative may incentivize firms to 
avoid testing datasets in order to avoid receiving information that 
would challenge their reasonable belief about the unbiased nature of 
their data.
4. Apply the Requirements of the Proposed Conflicts Rule and Proposed 
Recordkeeping Amendments Only to Broker-Dealer Use of Covered 
Technologies That Have Non-Recommendation Investor Interaction
    This alternative would limit the scope of the requirements to 
covered technologies used by broker-dealers in non-recommendation 
interactions with investors. Such an alternative would target those 
investor interactions that fall outside Reg BI's Conflict of Interest 
Obligation. These broker-dealer non-recommendation interactions can 
influence investor behavior due to advances in technology and the 
psychological biases of investors. Imposing requirements on broker-
dealer covered technologies that have non-recommendation interactions 
with investors would expand the set of investor interactions that have 
some form of conflict of interest obligation, requiring that broker-
dealers eliminate, or neutralize the effect of, certain conflicts of 
interest that arise in non-recommendation interactions covered by the 
proposed conflicts rule. This alternative would also place on certain 
non-recommendation interactions the proposed policies and procedures 
and recordkeeping obligations, including those related to testing.
    However, this alternative cedes the benefits and costs of the 
proposed conflicts rules' requirements for a large portion of investor 
interactions with covered technologies, namely those interactions with 
broker-dealers that involve a recommendation, and with investment 
advisers. These interactions would still be subject to existing 
conflict of interest obligations, but would not benefit from, for 
example, the proposed evaluation and identification (including testing) 
provisions or the requirement to eliminate, or neutralize the effects 
of, conflicts of interest that place the firm's or an associated 
person's interest ahead of investors' interests. In addition to 
forgoing these benefits, this alternative would result in non-
recommendation interactions being subject to more prescriptive 
requirements, and more documentation pursuant to the policies and 
procedures and recordkeeping elements of the proposal, than 
recommendation interactions, which could create frictions for broker-
dealers that use covered technologies that have both recommendation and 
non-recommendation interactions with investors.
    Another variation of this alternative would, in addition to the 
application of the requirements of the proposed conflicts rules to 
broker-dealer use of covered technology for non-recommendation investor 
interactions, apply the policy and procedures requirements and the 
recordkeeping requirements of the proposed conflicts rules and proposed 
recordkeeping amendments to investment adviser and broker-dealer use of 
covered technology with any investor interaction. This alternative 
would forgo the benefits and costs associated with the proposal's 
requirement to eliminate, or neutralize the effect of, certain 
conflicts of interest for advice and recommendation interactions. 
However, the alternative might strengthen existing conflict of interest 
obligations by requiring that firms have documented policies and 
procedures to evaluate the use of covered technologies, the conflicts 
of interest associated with their use, and the extent to which any 
conflicts of interest place the firm's interest ahead of the investors, 
which could yield investor protection benefits for investors. This 
alternative would impose the costs of the policies and procedures 
requirements and the recordkeeping requirements on firms.
5. Require That Firms Test Covered Technologies on an Annual Basis, or 
at a Specific Minimum Frequency
    This alternative would require that firms test covered technologies 
used in investor interactions on an annual basis at a minimum, instead 
of periodically as under the proposal. This alternative could enhance 
investor protection by ensuring that covered technologies used in 
investor interactions are tested regularly at a minimum level for 
conflicts of interest. However, this alternative could impose 
unnecessary costs on firms that use covered technologies which have 
relatively static potential for conflicts of interest. For example, an 
investment recommendation algorithm that bases its responses on a 
static data set and accepts limited input from investors from a simple 
questionnaire, might not need to be tested as frequently as push 
notifications based on a dataset that is frequently being updated. 
Similarly, a covered technology operating within a static business 
model or defined set of investor interactions might not need to be 
tested as frequently. Imposing a minimum testing frequency that would 
be adequate for the latter example would impose unnecessary costs on 
the former, and a minimum testing frequency that would be suitable for 
the former example might be too infrequent for the latter example, 
potentially exposing investors to unidentified conflicts of interest.

[[Page 54014]]

6. Require That Firms Provide a Prescribed and Standardized Disclosure
    This alternative would require that firms deliver to investors 
prescribed and standardized disclosure of conflicts of interest that 
place the firm's or an associated person's interest ahead of investors' 
interests, in lieu of the proposed conflicts rules' requirement to 
eliminate, or neutralize the effect of, such conflicts of 
interest.\336\ Firms would also have to file their disclosures with the 
Commission. This disclosure would be a free-standing form like Form 
CRS, but would focus on the conflicts of interest associated with 
covered technologies and their use in investor interactions. The 
prescribed and standardized disclosure would require information such 
as the technologies used, a brief description of how they work, the 
data used, any third-party service providers associated with the 
technology, and any conflicts of interest identified. This disclosure 
would be in addition to the firm's existing Reg BI, fiduciary duty, and 
other baseline disclosure obligations.
---------------------------------------------------------------------------

    \336\ However, the use of covered technology in investor 
interaction would still be subject to the firm's existing conflict 
of interest obligations, which might require the firm to eliminate 
or mitigate the conflict of interest.
---------------------------------------------------------------------------

    By providing a prescribed and standardized disclosure, the firm 
could address the effects of the conflicts of interest by providing 
additional information and context in a format that is more easily 
understood by investors. A prescribed and standardized disclosure could 
also reduce the costs to investors to understand and interpret 
information about covered technologies. In addition, these disclosures 
might allow investors to more easily compare the conflicts of interest 
that firms have, or understand which firms use the same or similar 
underlying covered technologies.
    However, it is not clear that prescribing a standardized disclosure 
would be sufficient to enable investors to provide informed consent or 
otherwise achieve the investor protection goals of the proposed rules. 
In particular, disclosure may be ineffective in light of, as discussed 
in section III.B, the rate of investor interactions and the ability of 
the technology to learn investor preferences or behavior, which could 
entail providing disclosure that is highly technical and variable. 
Firms might have difficulty fully conveying the scope of conflicts of 
interest generated by the use of covered technologies, which could 
hamper its ability to address the effects of conflicts of interest they 
generate. And, as previously discussed, disclosures may be too lengthy 
to be meaningful or actionable.\337\ Conflicts disclosure may also, for 
example, lead to under- or over-reaction by investors: investors may 
not know how to respond to information about conflicts and therefore 
fail to adequately adjust their behavior, or may overreact to 
disclosures of conflicts of interest and therefore forgo valuable 
investment advice.\338\
---------------------------------------------------------------------------

    \337\ See supra note 248 and surrounding text.
    \338\ See, e.g., James M. Lacko & Janis K. Pappalardo, The 
Effect of Mortgage Broker Compensation Disclosures on Consumers and 
Competition: A Controlled Experiment, Federal Trade Commission, 
Bureau of Economics Staff Report (Feb. 2004), https://www.ftc.gov/sites/default/files/documents/reports/effect-mortgage-broker-compensation-disclosures-consumers-and-competition-controlled-experiment/030123mortgagefullrpt.pdf (documenting that when mortgage 
customers receive information about mortgage broker compensation 
through disclosures, such disclosures lead to an increase in more 
expensive loans and create a bias against broker-sold loans, even 
when the broker-sold loans are the more cost effective option); 
George Loewenstein, Cass R. Sunstein, & Russell Golman, Disclosure: 
Psychology Changes Everything, 6 Ann. Rev. Econ. 391 (2014). See 
also Reg BI Adopting Release, supra note 8, at III.B.4.c. 
(discussing the effectiveness and limitations of disclosure). See 
also SEC Staff Study Regarding Financial Literacy Among Investors, 
August 2012, at https://www.sec.gov/news/studies/2012/917-financial-literacy-study-part1.pdf.
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G. Request for Comment

    We request comment on all aspects of the economic analysis of the 
proposed conflicts rules and proposed recordkeeping amendments. To the 
extent possible, we request that commenters provide supporting data and 
analysis with respect to the benefits, costs, and effects on 
competition, efficiency, and capital formation of adopting the proposed 
conflicts rules and proposed recordkeeping amendments or any reasonable 
alternatives. In particular, we ask commenters to consider the 
following questions:
    94. What additional regulatory, qualitative, or quantitative 
information should be considered as part of the baseline for the 
economic analysis of the proposed conflicts rules and proposed 
recordkeeping amendments?
    95. The Commission seeks comment on the types of technologies that 
are currently in use that could potentially be affected by the proposed 
conflicts rules and proposed recordkeeping amendments. Have they been 
accurately characterized? If not, why not? Are there any technologies 
that haven't been included, that should be? Are there any technologies 
that have been included, that shouldn't be? Is the simpler and complex 
technology distinction discussed in this release sufficient to describe 
the cost burdens of technologies?
    96. The Commission seeks comment on the conflicts of interest 
associated with the use of covered technologies. What types of 
conflicts of interest are associated with the use of these 
technologies? What costs do they impose on investors? What practices 
exist for eliminating, or neutralizing the effect of, these conflicts 
of interest? What practices exist for mitigating the effects of these 
conflicts of interest? What are the current costs of these methods?
    97. Are the costs and benefits of the proposed conflicts rules and 
proposed recordkeeping amendments accurately characterized? If not, why 
not? Should any of the costs or benefits be modified? What, if any, 
other costs or benefits should be taken into account? If possible, 
please offer ways of estimating these costs and benefits. What 
additional considerations can be used to estimate the costs and 
benefits of the proposed conflicts rules and proposed recordkeeping 
amendments?
    98. Are the effects on competition, efficiency, and capital 
formation arising from the proposed conflicts rules and proposed 
recordkeeping amendments accurately characterized? If not, why not?
    99. The Commission seeks comment on the potential costs associated 
with the proposed conflicts rules and proposed recordkeeping 
amendments. What types of costs are likely to be incurred by firms in 
order to comply with the proposed conflicts rules and proposed 
recordkeeping amendments? How might these costs vary depending on the 
types of technology, the business model, or the nature and extent of 
investor interactions used by the firms? To what extent do firms 
already incur these costs in order to comply with their existing 
obligations? What costs would there be for investors?
    100. The Commission seeks comment on the types of labor and other 
resources that would be required for firms to comply with the proposed 
conflicts rules and proposed recordkeeping amendments. What personnel 
would need to be involved in complying with the proposed conflicts 
rules and proposed recordkeeping amendments? What types of expertise 
would be required? How might the size and complexity of a firm impact 
the resources needed to comply with the proposed conflicts rules and 
proposed recordkeeping amendments?
    101. The Commission seeks comment on how the proposed conflicts 
rules and proposed recordkeeping amendments might impact a firm's or a 
technology

[[Page 54015]]

provider's software development process. What changes might be 
necessary in order to help ensure that firms using covered technologies 
in investor interactions are in compliance with the proposed conflicts 
rules and proposed recordkeeping amendments? How might the proposed 
conflicts rules and proposed recordkeeping amendments impact the speed 
or efficiency of software development?
    102. The Commission seeks comment on the potential impact of the 
proposed conflicts rules and proposed recordkeeping amendments on 
smaller firms, or firms with simpler or more transparent covered 
technologies. What additional costs might these firms face in order to 
comply with the proposed conflicts rules and proposed recordkeeping 
amendments? How might these costs impact smaller firms and their 
investors differently than larger firms and their investors?
    103. The Commission seeks comment on the potential benefits of the 
proposed conflicts rules and proposed recordkeeping amendments. How 
might the proposed conflicts rules and proposed recordkeeping 
amendments improve transparency and fairness in the use of covered 
technologies? What impact might this have on investor confidence and 
trust in the market?
    104. The Commission seeks comment on the potential alternatives to 
the proposed conflicts rules and proposed recordkeeping amendments. Are 
there other approaches that might be more effective at achieving the 
goals of the proposed conflicts rules and proposed recordkeeping 
amendments? What trade-offs might be involved in pursuing these 
alternatives?
    105. Are the economic effects of the above alternatives accurately 
characterized? If not, why not? Should any of the costs or benefits be 
modified? What, if any, other costs or benefits should be taken into 
account?
    106. Are there other reasonable alternatives to the proposed 
conflicts rules and proposed recordkeeping amendments that should be 
considered? What are the costs, benefits, and effects on competition, 
efficiency, and capital formation of any other alternatives?

IV. Paperwork Reduction Act

A. Introduction

    Certain provisions of our proposal would result in new ``collection 
of information'' requirements within the meaning of the Paperwork 
Reduction Act of 1995 (``PRA'').\339\ Proposed rule 15l-2 under the 
Exchange Act and proposed rule 211(h)(2)-4 under the Advisers Act would 
result in new collection of information burdens and related amendments 
to rule 17a-3 and 17a-4 under the Exchange Act and rule 204-2 under the 
Advisers Act and would have an impact on current collection of 
information burdens. The titles of the new collection of information 
requirements we are proposing are ``Rule 211(h)(1)-4 under the Advisers 
Act'' and ``Rule 15l-2 under the Exchange Act.'' The Office of 
Management and Budget (``OMB'') has not yet assigned control numbers 
for these new collections of information. The titles for the existing 
collections of information that we are proposing to amend are: (i) 
``Rule 204-2 under the Investment Advisers Act of 1940'' (OMB control 
number 3235-0278); and (ii) ``Rule 17a-3 and Rule 17a-4 under the 
Exchange Act'' (OMB control numbers 3235-0033 and 3235-0279). The 
Commission is submitting these collections of information to the OMB 
for review and approval in accordance with 44 U.S.C. 3507(d) and 5 CFR 
1320.11. An agency may not conduct or sponsor, and a person is not 
required to respond to, a collection of information unless it displays 
a currently valid OMB control number.
---------------------------------------------------------------------------

    \339\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    We discuss below the new collection of information burdens 
associated with the proposed new rules, and amendments to existing 
rules. Responses provided to the Commission in the context of its 
examination and oversight program concerning the proposed rules and 
corresponding amendments would be kept confidential subject to the 
provisions of applicable law. A description of the proposed new rules 
and proposed amendments to existing rules, including the need for the 
information and its use, as well as a description of the types of 
respondents, can be found in section II above, and a discussion of the 
expected economic effects of the proposed new rules and proposed 
amendments to existing rules can be found in section III above.

B. Proposed Conflicts Rules and Proposed Recordkeeping Amendments

    The proposed conflicts rules are designed to address the conflicts 
of interest associated with firms' use of certain technology when 
engaging in certain investor interactions. As discussed in greater 
detail above, the proposed conflicts rules would generally require the 
elimination or neutralization of the effects of certain conflicts of 
interest. Specifically, paragraph (b) of the proposed conflicts rules 
would require a firm to (i) evaluate any use or reasonably foreseeable 
potential use by the firm of a covered technology in any investor 
interaction to identify any conflict of interest associated with that 
use or potential use (including by testing each such covered technology 
prior to its implementation or material modification, and periodically 
thereafter, to determine whether the use of such covered technology is 
associated with a conflict of interest); (ii) determine whether any 
such conflict of interest places or results in placing the firm's or an 
associated persons interest ahead of investors' interests; and (iii) 
eliminate, or neutralize the effect of, any such conflict of 
interest.\340\ As also discussed above, paragraph (c) of the proposed 
rules would require a firm that has any investor interaction using 
covered technology to adopt, implement, and in the case of broker-
dealers, maintain written policies and procedures that are, in the case 
of investment advisers, reasonably designed to prevent violations of, 
or in the case of broker-dealers, reasonably designed to achieve 
compliance with, paragraph (b) of the rules.
---------------------------------------------------------------------------

    \340\ See proposed rule 211(h)(2)-4(b); see also supra sections 
II.A.1 and II.A.2.c.
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    We believe that paragraph (c) constitutes a collection of 
information. We do not believe that the proposed requirements under 
paragraph (b) constitute an independent information collection. But, to 
the extent they do, we believe that the process firms would engage in 
to comply with the policies and procedures requirements under paragraph 
(c) of the proposed conflicts rules, and the information collection 
burden related thereto, are inextricable from any information 
collection burden under paragraph (b) of the proposed conflicts rules. 
Therefore, the information collection burden resulting from the 
policies and procedures required under the proposed conflicts rules 
would constitute the full burden of the rules.
    Finally, the proposed recordkeeping amendments would require 
investment advisers that are registered or required to be registered 
under the Advisers Act and broker-dealers that use covered technologies 
in investor interactions to make and maintain written records 
documenting compliance with the requirements of the proposed conflicts 
rules. Under the proposed recordkeeping amendments, the time periods 
for preserving records would vary between those for investment advisers 
that are registered or required to be registered under the Advisers Act 
and broker-dealers, in accordance with the existing recordkeeping rules 
that

[[Page 54016]]

would be amended.\341\ Time periods for maintaining records where they 
are easily accessible would be the same between investment advisers and 
broker-dealers.\342\
---------------------------------------------------------------------------

    \341\ Pursuant to current rule 204-2(e)(1), the records required 
to be maintained and preserved under proposed amendments to rule 
204-2 under the Advisers Act would be required to be maintained and 
preserved in an easily accessible place for a period of not less 
than five years from the end of the fiscal year during which the 
last entry was made on such record, the first two years in an 
appropriate office of the investment adviser. For broker-dealers, 
rule 17a-4(a) requires that records be ``preserve[d] for a period of 
not less than 6 years, the first two years in an easily accessible 
place.'' See also supra section II.B.
    \342\ See id.
---------------------------------------------------------------------------

    Each of the proposed requirements to obtain or maintain information 
constitutes a ``collection of information'' requirement under the PRA 
and is mandatory. These proposed collections are designed to require 
firms to have an established framework for eliminating or neutralizing 
conflicts of interest that could harm clients and which we believe 
would assist these firms in complying with the requirements under 
paragraph (b)(3) of the proposed rules. Accordingly, we believe the 
proposal would have investor protection benefits. Additionally, the 
Commission's staff could use the information obtained through these 
collections in its enforcement, regulatory, and examination programs. 
The respondents to these collections of information requirements would 
be investment advisers that are registered or required to be registered 
under the Advisers Act and broker-dealers that are registered under the 
Exchange Act that used covered technologies in investor interactions.
    As of February 28, 2023, there were 15,402 investment advisers 
registered with the Commission \343\ and 3,504 \344\ broker-dealers 
registered with the Commission. We believe that substantially all of 
the 15,402 registered investment advisers would be subject to the 
proposed rules and, based on an analysis of filings by these firms 
performed by the staff, we believe that approximately 2,575 \345\ 
broker-dealers would be subject to the proposed rules.
---------------------------------------------------------------------------

    \343\ Based on IARD data as of Mar. 27, 2023.
    \344\ Based on FOCUS Filing data, as of Mar. 2023.
    \345\ Consistent with the Form CRS Adopting Release, we estimate 
that 73.5% of registered broker-dealers report retail activity and 
thus, would likely be subject to the proposed rules. However, we 
recognize this may capture some broker-dealers that do not have 
retail activity.
---------------------------------------------------------------------------

    The application of the provisions of the proposed conflicts rules 
and proposed recordkeeping amendments--and thus the extent to which 
there are collections of information and their related burdens--would 
be contingent on a number of factors, such as, among others, the types 
of covered technologies a firm uses, a firm's business model, the 
number of clients or customers of the firm, the extent, nature and 
frequency of investor interactions, and the nature and extent of its 
conflicts. Because of the wide diversity of services and relationships 
offered by firms, we expect that the obligations imposed by the 
proposed rules would, accordingly, vary substantially. However, we have 
made certain estimates of this data solely for the purpose of this PRA 
analysis.

                                         Table 3--Proposed Conflicts Rules and Proposed Recordkeeping Amendments
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                       Internal initial       Internal annual                                  Internal time cost   Annual external cost
                                       burden hours \1\       burden hours \2\           Wage rate \3\                 \4\               burden \5\
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   PROPOSED ESTIMATES
--------------------------------------------------------------------------------------------------------------------------------------------------------
Adopting and implementing policies  21 hours.............  30 hours.............  $487 (blended rate for      $14,610 (equal to     $0.
 and procedures.                                                                   senior corporate and        the internal annual
                                                                                   information technology      burden x the wage
                                                                                   managers, assistant         rate).
                                                                                   general counsel, and
                                                                                   compliance attorney).
Preparation of written              60 hours.............  42.5 hours...........  $446 (blended rate for      $18,955 (equal to     $0.
 descriptions \6\.                                                                 senior corporate and        the internal annual
                                                                                   information technology      burden x the wage
                                                                                   managers and staff,         rate).
                                                                                   assistant general
                                                                                   counsel, and compliance
                                                                                   attorney).
Annual review of policies and       .....................  5 hours..............  $446 (blended rate for      $2,230 (equal to the  $0.
 procedures and written                                                            senior corporate and        internal annual
 descriptions.                                                                     information technology      burden hours x the
                                                                                   managers and staff,         wage rate).
                                                                                   assistant general
                                                                                   counsel, and compliance
                                                                                   attorney).
Recordkeeping requirements \7\....  N/A..................  18.5 hours...........  $412 (blended rate for      $7,622 (equal to the  $0.
                                                                                   compliance attorney,        internal annual
                                                                                   senior programmer, and      burden hours x the
                                                                                   senior corporate manager).  wage rate).
Total new annual burden...........  .....................  96 hours (equal to     ..........................  $43,417 (equal to     $0 (equal to the sum
                                                            the sum of the above                               the sum of the        of the above four
                                                            four boxes).                                       above four boxes).    boxes).
Number of investment advisers       .....................  x 15,402 covered       ..........................  x 15,402 covered      $0.
 covered.                                                   investment advisers                                investment advisers.
                                                            \7\.
Number of broker-dealers covered..  .....................  x 2,573 covered        ..........................  x 2,573 covered       $0.
                                                            broker-dealers.                                    broker-dealers.
Total new annual aggregate burden   .....................  1,478,592 hours......  ..........................  $668,708,634........  $0.
 for investment advisers covered.
Total new annual aggregate burden   .....................  247,008 hours........  ..........................  $ 111,711,941.......  $0.
 for broker-dealers covered.
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes:

[[Page 54017]]

 
\1\ In the case of investment advisers, most advisers using covered technology already have certain policies and procedures in place relevant to these
  technologies so as to fulfill the adviser's fiduciary duty, comply with the Federal securities laws, and protect clients from potential harm.
  Similarly, broker-dealers are already subject to extensive obligations, including certain policies and procedures requirements, under Federal
  securities laws and regulations, and rules of self-regulatory organizations (in particular, FINRA) that would apply to the extent PDA-like
  technologies are used in investor interactions that are subject to such existing obligations. In reaching our estimates, we considered that advisers
  and broker-dealers relying more heavily on complex covered technologies may exceed this average, while advisers and broker-dealers relying less
  heavily on these technologies may fall below this average.
\2\ Totals for this category include internal initial hour burden estimates annualized over a three-year period.
\3\ The Commission's estimates of the relevant wage rates are based on salary information for the securities industry compiled by Securities Industry
  and Financial Markets Association's Office Salaries in the Securities Industry 2013, as modified by Commission staff for 2023 (``SIFMA Wage Report'').
  The estimated figures are modified by firm size, employee benefits, overhead, and adjusted to account for the effects of inflation.
\4\ All costs calculated are rounded to the nearest dollar.
\5\ Firms may incur third-party costs in connection with the proposed conflicts rules but, due to data limitations, for the purpose of this Paperwork
  Reduction Act analysis, we estimate the full cost of compliance to be internal. See supra section III.C.1. (discussing data limitations).
\6\ Includes all written descriptions to be required under proposed rules 275.211(h)(2)-4(c)(1) through (3) and 240.15l-2 (c)(1) through (3).
\7\ In our most recent Paperwork Reduction Act submission for rule 204-2, we estimated for rule 204-2 a total annual aggregate hour burden of 2,764,563
  hours, and a total annual aggregate external cost burden of $175,980,426. The table above summarizes the initial and ongoing annual burden estimates
  associated with the proposed amendments to rule 204-2. We have made certain estimates of the burdens associated with the proposed amendments solely
  for the purpose of this PRA analysis. We estimate that the proposed amendments would result in an aggregate burden of 284,937 hours (18.5 hours x
  15,402 advisers) and with an estimated aggregate internal monetized cost of $117,394,044 (284,937 hours x $412 blended rate of professional staff
  described above = $117,394,044). Based on our most recent Paperwork Reduction Act submission, we believe that the total burden under rule 204-2,
  including the proposed amendments to rule 204-2, amount to 3,049,500 hours with a total internal monetized cost of $293,374,470.

C. Request for Comment

    We request comment on whether these estimates are reasonable. 
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments 
in order to: (i) evaluate whether the proposed collection of 
information is necessary for the proper performance of the functions of 
the Commission, including whether the information will have practical 
utility; (ii) evaluate the accuracy of the Commission's estimate of the 
burden of the proposed collection of information; (iii) determine 
whether there are ways to enhance the quality, utility, and clarity of 
the information to be collected; and (iv) determine whether there are 
ways to minimize the burden of the collection of information on those 
who are to respond, including through the use of automated collection 
techniques or other forms of information technology. Persons wishing to 
submit comments on the collection of information requirements of the 
proposed amendments should direct them to the OMB Desk Officer for the 
Securities and Exchange Commission, 
[email protected], and should send a copy to 
Vanessa A. Countryman, Secretary, Securities and Exchange Commission, 
100 F Street NE, Washington, DC 20549-1090, with reference to File No. 
S7-12-23. OMB is required to make a decision concerning the collections 
of information between 30 and 60 days after publication of this 
release; therefore, a comment to OMB is best assured of having its full 
effect if OMB receives it within 30 days after publication of this 
release. Requests for materials submitted to OMB by the Commission with 
regard to these collections of information should be in writing, refer 
to File No. S7-12-23, and be submitted to the Securities and Exchange 
Commission, Office of FOIA Services, 100 F Street NE, Washington, DC 
20549-2736.

V. Initial Regulatory Flexibility Analysis

    The Commission has prepared the following Initial Regulatory 
Flexibility Analysis (``IRFA'') in accordance with section 3(a) of the 
Regulatory Flexibility Act.\346\ It relates to: (i) proposed rule 151-2 
under the Exchange Act and proposed rule 211(h)(2)-4 under the Advisers 
Act; and (ii) proposed amendments to rules 17a-3 and 17a-4 under the 
Exchange Act and rule 204-2 under the Advisers Act.
---------------------------------------------------------------------------

    \346\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

A. Reason for and Objectives of the Proposed Action

    The reasons for, and objectives of, the proposed rules and 
amendments are discussed in more detail in sections I and II, above. 
The burdens of these requirements on small advisers and broker-dealers 
are discussed below as well as above in sections III and IV, which 
discuss the burdens on all advisers and broker-dealers. Sections II 
through IV discuss the professional skills that we believe compliance 
with the proposed rules and amendments would require.
1. Proposed Rules 151-2 and 211(h)(2)-4
    We are proposing rules 15l-2 under the Exchange Act and 211(h)(2)-4 
under the Advisers Act (collectively, the ``conflicts rules'') which, 
generally, would require investment advisers and broker-dealers 
registered with the Commission to take certain steps to eliminate, or 
neutralize the effect of, certain conflicts of interest from these 
firms' use of covered technology when engaging in certain investor 
interactions. As firms adopt and utilize covered technologies at an 
increasingly rapid pace, the risk of conflicts of interest associated 
with the use of those technologies becomes increasingly pronounced and 
potentially harmful on a broader scale than previously possible. In 
addition, the conflicts associated with a firm's use of these 
technologies may expose investors to unique and opaque conflicts of 
interest for which disclosure may not possible or sufficient and which 
may not otherwise be sufficiently addressed by the existing legal 
framework. The proposed conflicts rules, therefore, would require a 
firm to identify and evaluate whether any use or potential use by the 
firm of a covered technology in any investor interaction involves a 
conflict of interest, determine whether any such conflict of interest 
results in an investor interaction that places the firm's or an 
associated person's interest ahead of investors' interests, and 
eliminate, or neutralize the effect of, any such conflict of interest.
    The proposed conflicts rules would also require a firm that has any 
investor interaction using covered technology to adopt, implement, and, 
in the case of broker-dealers, maintain, written policies and 
procedures reasonably designed to achieve compliance with the 
elimination and neutralization of effect of conflicts of interest 
requirement. These proposed policies and procedures requirements, as 
well as the written descriptions and annual review to be required by 
those policies and procedures, are designed to require firms to have an 
established framework for eliminating, or neutralizing the effect of, 
conflicts of interest that could harm clients and which we believe 
would assist these firms in complying with the requirements under 
paragraph (b) of the proposed rules. The description would also assist 
the firm's internal staff, as well as examination staff, in assessing a 
firm's compliance. In turn, this design would help ensure that firms 
are appropriately eliminating, or neutralizing the effects of, any 
conflict of interest in accordance with the proposed rules.
    The proposed rules would require the policies and procedures to 
address certain matters that, collectively, are

[[Page 54018]]

designed to help ensure that a firm understands how its covered 
technologies work and the actual or potential conflicts they could 
involve. The policies and procedures would require a firm that has any 
investor interaction using covered technology to adopt, implement, and 
maintain written policies and procedures reasonably designed to achieve 
compliance with the proposed conflicts rules, including policies and 
procedures designed to require: (i) a written description of any 
material features of, including any conflicts of interest associated 
with the use of, any covered technology used in any investor 
interaction prior to such covered technology's implementation or 
material modification, which must be updated periodically thereafter; 
(ii) a written description of the process for determining whether any 
conflict of interest identified pursuant to the proposed conflicts 
rules places or results in placing the interest of the firm or person 
associated with the firm ahead of the interests of the investor; (iii) 
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 conflicts rules to result in an investor 
interaction that places the interest of the firm or person associated 
with the firm ahead of the interests of the investor; and (iv) a review 
and written documentation of that review, no less frequently than 
annually, of the adequacy of the policies and procedures established 
pursuant to the proposed conflicts rules and the effectiveness of their 
implementation as well as a review of the written descriptions 
established pursuant to the proposed conflicts rules.
    The proposed conflict rules are designed to promote investor 
protection while allowing continued technological innovation in the 
industry.
2. Proposed Amendments to Rules 17a-3 and 17a-4 and Rule 204-2
    Proposed amendments to rules 17a-3 and 17a-4, the books and records 
rules under the Exchange Act, and proposed amendments to rule 204-2, 
the books and records rule under the Advisers Act, would require firms 
to make and keep books and records related to the requirements of the 
proposed conflicts rules and are designed to help facilitate the 
Commission's examination and enforcement capabilities by creating 
records staff can use to assess compliance with the requirements of the 
proposed conflicts rules, and to help facilitate assessment by firm 
compliance staff of such compliance. The rules would require firms to 
maintain six types of records, as follows, and as more fully described 
in section II above: (1) written documentation of the evaluation 
conducted pursuant to paragraph (b)(1) of the proposed conflicts rules, 
including a list or other record of all covered technologies used by 
the firm in investor interactions, as well as documentation describing 
any testing of the covered technology in accordance with paragraph 
(b)(1) of the proposed conflicts rules; (2) written documentation of 
each determination made pursuant to paragraph (b)(2) of the proposed 
conflicts rules, including the rationale for such determination; (3) 
written documentation of each elimination or neutralization made 
pursuant to paragraph (b)(3) of the proposed conflicts rules; (4) 
written policies and procedures, including written descriptions, 
prepared in accordance with paragraph (c) of the proposed conflicts 
rules; (5) a record of the disclosures provided to investors regarding 
the firm's use of covered technologies; and (6) records of each 
instance in which a covered technology was altered, overridden, or 
disabled, the reason for such action, and the date thereof, as well as 
records of all instances where an investor requested that a covered 
technology be altered or restricted in any manner.

B. Legal Basis

    The Commission is proposing the new rules and rule amendments 
described above under the authority set forth in sections 204 and 211 
of the Investment Advisers Act of 1940 (15 U.S.C. 80b-4 and 80(b)-11) 
and sections 15 and 17 of the Securities Exchange Act of 1934 (15 
U.S.C. 78j).

C. Small Entities Subject to the Rules and Rule Amendments

    In developing these proposals, we have considered their potential 
impact on small entities that would be subject to the proposed rules 
and rule amendments. The proposed rules and amendments would affect 
investment advisers registered, or required to be registered, with the 
Commission and broker-dealers registered with the Commission, including 
some small entities.
1. Small Advisers Subject to Proposed Rule 211(h)(2)-4 and Proposed 
Amendments to Recordkeeping Rule
    Under Commission rules under the Advisers Act, for the purposes of 
the RFA, an investment adviser generally is a small entity if it: (i) 
has assets under management having a total value of less than $25 
million; (ii) did not have total assets of $5 million or more on the 
last day of the most recent fiscal year; and (iii) does not control, is 
not controlled by, and is not under common control with another 
investment adviser that has assets under management of $25 million or 
more, or any person (other than a natural person) that had total assets 
of $5 million or more on the last day of its most recent fiscal year. 
Our proposed rules and amendments would not affect most investment 
advisers that are small entities (``small advisers'') because they are 
generally registered with one or more state securities authorities and 
not with the Commission. Under section 203A of the Advisers Act, most 
small advisers are prohibited from registering with the Commission and 
are regulated by state regulators. We estimate that approximately 489 
SEC-registered advisers are small entities under the RFA.\347\
---------------------------------------------------------------------------

    \347\ Based on IARD data as of Dec. 31, 2022.
---------------------------------------------------------------------------

    As discussed above in section IV (the Paperwork Reduction Act 
Analysis), the Commission estimates that based on IARD data through 
March 31, 2023, approximately 15,402 investment advisers would be 
subject to proposed rule 211(h)(2)-4 and the related amendments to the 
recordkeeping rule. We estimate that all of the approximately 489 SEC-
registered advisers that are small entities under the RFA would be 
subject to the proposed conflicts rules and amendments to the 
recordkeeping rule.

D. Small Broker-Dealers Subject to Proposed Conflicts Rule and 
Amendments to Recordkeeping Rules

    For purposes of the RFA, under the Exchange Act a broker or dealer 
is a small entity if it: (i) had total capital of less than $500,000 on 
the date in its prior fiscal year as of which its audited financial 
statements were prepared or, if not required to file audited financial 
statements, on the last business day of its prior fiscal year; and (ii) 
is not affiliated with any person that is not a small entity.\348\ 
Based on Commission filings, we estimate that approximately 764 broker-
dealers may be considered small entities.\349\
---------------------------------------------------------------------------

    \348\ 17 CFR 240.0-10.
    \349\ Estimate based on FOCUS Report data collected by the 
Commission as of Sept. 30, 2022.
---------------------------------------------------------------------------

E. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

    The proposed conflicts rules and amendments to rule 204-2 and to 
rules 17a-3 and 17a-4 would impose certain compliance and recordkeeping 
requirements on those investment advisers and broker-dealers subject to 
the terms of the rules, including those

[[Page 54019]]

that are small entities. All advisers and broker-dealers that have any 
investor interaction using covered technology would be subject to the 
proposed conflict rules' requirement to adopt, implement, and (in the 
case of broker-dealers) maintain written policies and procedures 
reasonably designed to achieve compliance with the proposed conflicts 
rules. These firms would also be subject to the recordkeeping 
requirements in the proposed amendments to rule 204-2 and rules 17a-3 
and 17a-4. The proposed requirements and rule amendments, including 
compliance, reporting, and recordkeeping requirements, are summarized 
in this IRFA (section V.A., above). All of these proposed requirements 
are also discussed in detail, above, in sections I and II, and these 
requirements and the burdens on respondents, including those that are 
small entities, are discussed above in sections III and IV (the 
Economic Analysis and Paperwork Reduction Act Analysis, respectively) 
and below. The professional skills required to meet these specific 
burdens are also discussed in section IV.
1. Proposed Conflicts Rules
    As discussed above, approximately 489 small advisers were 
registered with us as of December 31, 2022, and we estimate that all of 
these advisers would be subject to proposed rule 211(h)(2)-4. As 
discussed above in our Paperwork Reduction Act Analysis in section IV 
above, proposed rule 211(h)(2)-4 would create an annual burden of 
approximately 77.5 hours per adviser, or 37,897.5 hours in aggregate 
for small advisers.\350\ We therefore expect that the annual monetized 
aggregate cost to small advisers associated with proposed rule 
211(h)(2)-4 would be $17,432,850.\351\
---------------------------------------------------------------------------

    \350\ 77.5 hours x 489 small advisers subject to the proposed 
rule and rule amendments.
    \351\ $460 (blended rate for professionals assisting with 
adopting and implementing policies and procedures, (ii) preparation 
of written descriptions, and (iii) annual review of policies and 
procedures and written descriptions) x 37,897.55 hours.
---------------------------------------------------------------------------

    As discussed above, approximately 764 broker-dealers may be 
considered small entities as of September 30, 2022, and we estimate 
that 562 \352\ of those small registered broker-dealers would be 
subject to the proposed amendments (73.5% of all registered small 
broker-dealers). As discussed above in our Paperwork Reduction Act 
Analysis in section IV above, proposed rule 15-2 would create an annual 
burden of approximately 77.5 hours per broker-dealers, 43,555 hours in 
aggregate for small broker-dealers.\353\ We therefore expect that the 
annual monetized aggregate cost to small broker-dealers associated with 
proposed rule 15l-2 would be $20,035,300.\354\
---------------------------------------------------------------------------

    \352\ 2,573 (estimated number of broker-dealers subject to 
proposed rule and rule amendments)/3,501 (number of registered 
broker-dealers) = 0.735 (estimated ratio of broker-dealers subject 
to rule and rule amendments). 0.735 x 764 (number of small broker-
dealers) = 562 small broker-dealers subject to proposed rule and 
rule amendments.
    \353\ 77.5 hours x 562 small broker-dealers subject to the 
proposed rule and rule amendments.
    \354\ $460 (blended rate for professionals assisting with 
adopting and implementing policies and procedures, (ii) preparation 
of written descriptions, and (iii) annual review of policies and 
procedures and written descriptions) x 43,555 hours.
---------------------------------------------------------------------------

2. Proposed Amendments to Rule 204-2
    The proposed amendments to rule 204-2 would impose certain 
recordkeeping requirements on investment advisers using covered 
technology in interactions with investors. The proposed amendments, 
including recordkeeping requirements, are summarized above in this IRFA 
(section V.A). All of these proposed requirements are also discussed in 
detail, above, in section II, and these requirements and the burdens on 
respondents, including those that are small entities, are discussed 
above in sections III and IV (the Economic Analysis and Paperwork 
Reduction Act Analysis) and below. The professional skills required to 
meet these specific burdens are also discussed in section IV.
    Our Economic Analysis (section III above) discusses these costs and 
burdens for respondents, which include small advisers. As discussed 
above in our Paperwork Reduction Act Analysis in section IV above, the 
proposed amendments to rule 204-2 would create an annual burden of 
approximately 18.5 hours per adviser. Based on our estimate of 489 
advisers subject to the proposed amendments to the rule, we estimate 
the aggregate burden on small advisers to amount to 9,046.5 hours.\355\ 
We therefore expect that the annual monetized aggregate cost to small 
advisers associated with the proposed amendments to rule 204-2 would be 
$3,727,158.\356\
---------------------------------------------------------------------------

    \355\ 18.5 hours x 489 advisers.
    \356\ $412 (blended rate for compliance attorney, senior 
programmer, and senior corporate manager) x 9,046.5 hours.
---------------------------------------------------------------------------

3. Proposed Amendments to Rules 17a-3 and 17a-4
    The proposed amendments to rules 17a-3 and 17a-4 would impose 
certain recordkeeping requirements on broker-dealers using covered 
technology in interactions with investors. The proposed amendments, 
including recordkeeping requirements, are summarized above in this IRFA 
(section V.A). All of these proposed requirements are also discussed in 
detail, above, in section II, and these requirements and the burdens on 
respondents, including those that are small broker-dealers, are 
discussed above in sections III and IV (the Economic Analysis and 
Paperwork Reduction Act Analysis) and below. The professional skills 
required to meet these specific burdens are also discussed in section 
IV.
    Our Economic Analysis (section III above) discusses these costs and 
burdens for respondents, which include small broker-dealers. As 
discussed above in our Paperwork Reduction Act Analysis in section IV 
above, the proposed amendments to rules 17a-3 and 17a-4 would create an 
annual burden of approximately 18.5 hours per broker-dealer. Based on 
our estimate of 562 small broker-dealers subject to the proposed 
amendments to the rule, we estimate the aggregate burden on small 
broker-dealers to amount to 10,397 hours.\357\ We therefore expect that 
the annual monetized aggregate cost to small broker-dealers associated 
with the proposed amendments to rules 17a-3 and 17a-4 would be 
$4,283,564.\358\
---------------------------------------------------------------------------

    \357\ 18.5 hours x 562 small broker-dealers.
    \358\ $412 (blended rate for compliance attorney, senior 
programmer, and senior corporate manager) x 10,397 hours.
---------------------------------------------------------------------------

F. Duplicative, Overlapping, or Conflicting Federal Rules

1. Proposed Rule 211(h)(2)-4 and Proposed Amendments to Rule 204-2
    In proposing rule 211(h)(2)-4, we recognize that investment 
advisers today are subject to a number of laws, rules, and regulations 
which indirectly address the oversight of the way an adviser relies on 
and uses technology in its interactions with advisory clients. As 
discussed in section I and section III.C.3, their fiduciary duty 
requires them to take steps to protect client interests, which would 
include steps to provide investment advice that it reasonably believes 
is in the best interest of the client regardless of whether the adviser 
is using a covered technology in an investor interaction. This duty 
requires investment advisers to eliminate a conflict of interest or, at 
a minimum, make full and fair disclosure of the conflict of interest 
such that a client can provide informed consent to the conflict.\359\ 
Investment advisers are subject to the antifraud provisions found in 
section 206 of the

[[Page 54020]]

Advisers Act,\360\ which prohibits fraud or deceit upon any client or 
prospective client; rule 206(4)-8 under the Advisers Act, which makes 
it unlawful for any investment adviser to a pooled investment vehicle 
to engage in fraud or deceit upon any investor or prospective investor 
in the pooled investment vehicle; \361\ and Exchange Act rule 10b-5, 
which makes it unlawful for any person to engage in fraud or deceit 
upon any person.\362\ Advisers are also subject to the Advisers Act 
Compliance Rule, requiring advisers to adopt, implement, and annually 
review written policies and procedures reasonably designed to prevent 
violations of the Act and the rules thereunder,\363\ and rule 206(4)-1 
under the Advisers Act, prohibiting advisers from disseminating any 
advertisement that violates any requirements of that rule, including 
making untrue statements of material fact or misleading omissions and 
discussing any potential benefits connected with or resulting from the 
investment adviser's services or methods of operation without providing 
fair and balanced treatment of any material risks or material 
limitations associated with the potential benefits.\364\ Individually 
and collectively, these impose obligations on an adviser's use of 
covered technologies in investor interactions depending on how the 
adviser uses the technology.
---------------------------------------------------------------------------

    \359\ See Fiduciary Interpretation, supra note 8, at section II.
    \360\ 15 U.S.C. 80b-6.
    \361\ 17 CFR 275.206(4)-8.
    \362\ 17 CFR 240.10b-5.
    \363\ See rule 206(4)-7.
    \364\ See rule 206(4)-1(a)(1), (4).
---------------------------------------------------------------------------

    However, investment advisers do not have specific obligations under 
the Advisers Act or any of its rules to eliminate, or neutralize the 
effect of, conflicts of interest promptly after the adviser identifies, 
or reasonably should have identified, such conflict of interest.\365\ 
Further, the Advisers Act compliance rule is principles based and, as 
such, does not require specific elements that would be required under 
the policies and procedures requirements of the proposed conflict 
rule.\366\ Similarly, existing recordkeeping obligations do not 
specifically require the records that firms would be required to keep 
under the proposed amendments to that rule.\367\ The proposed rules 
would provide a comprehensive oversight framework, consisting of 
targeted obligations, policies and procedures, and recordkeeping 
requirements, which we believe would be complementary to existing 
obligations and practices rather than duplicative or conflicting. To 
the extent there is overlap among the existing and proposed 
requirements, it is incomplete overlap and would ease burdens on 
smaller firms in complying with the proposed rules.
---------------------------------------------------------------------------

    \365\ See proposed rule 211(h)(2)-4(b).
    \366\ See proposed rule 211(h)(2)-4(c).
    \367\ See proposed rule 204-2.
---------------------------------------------------------------------------

2. Proposed Rule 151-2 and Proposed Amendments to Rules 17a-3 and 17a-4
    As noted above, broker-dealers are currently subject to extensive 
obligations under Federal securities laws and regulations, and rules of 
self-regulatory organizations (in particular, FINRA), that are designed 
to promote conduct that, among other things, protects investors from 
conflicts of interest.\368\ To the extent PDA-like technologies are 
used in investor interactions that are subject to existing obligations 
(including, but not limited to, obligations related to recommendations, 
general and specific requirements aimed at addressing certain conflicts 
of interest, including requirements to eliminate, mitigate or disclose 
certain conflicts of interest, disclosure of firms' services, fees and 
costs, disclosure of certain business practices, communications with 
the public, supervision, and obligations related to policies and 
procedures), those obligations would apply. In addition to these 
obligations, Federal securities laws and regulations broadly prohibit 
fraud by broker-dealers as well as fraud by any person in the offer, 
purchase, or sale of securities, or in connection with the purchase or 
sale of securities. However, broker-dealers do not have specific 
obligations under the Exchange Act or any of its rules to eliminate, or 
neutralize the effect of, conflicts of interest in the same way as 
required under proposed rule 151-2. Similarly, while existing 
recordkeeping obligations apply more generally to ``business'' records, 
they do not specifically require the records that firms would be 
required to keep under the proposed amendments to the proposed conflict 
rule for broker-dealers. The proposed rules would provide a 
comprehensive oversight framework, consisting of targeted obligations, 
policies and procedures, and recordkeeping requirements, which we 
believe would be complementary to existing obligations and practices 
rather than duplicative or conflicting. To the extent there is overlap 
among the existing and proposed requirements, it is incomplete overlap 
and would ease burdens on smaller firms in complying with the proposed 
rules.
---------------------------------------------------------------------------

    \368\ See Reg BI Adopting Release, supra note 8, at section 
II.A.1. (The ``without placing the financial or other interest . . . 
ahead of the interest of the retail customer'' phrasing recognizes 
that while a broker-dealer will inevitably have some financial 
interest in a recommendation--the nature and magnitude of which will 
vary--the broker-dealer's interests cannot be placed ahead of the 
retail customer's interest''). Additionally, broker-dealers often 
provide a range of services that do not involve a recommendation to 
a retail customer--which is required in order for Reg BI to apply--
and those services are subject to general and specific requirements 
to address associated conflicts of interest under the Exchange Act, 
Securities Act of 1933, and relevant SRO rules as applicable. See, 
e.g., Reg BI Proposing Release, supra note 8; see also FINRA 
Conflict Report, supra note 60, at Appendix I (Conflicts Regulation 
in the United States and Selected International Jurisdictions) 
(describing broad obligations under SEC and FINRA rules as well as 
specific conflicts-related disclosure requirements under FINRA 
rules).
---------------------------------------------------------------------------

G. Significant Alternatives

    The RFA directs the Commission to consider significant alternatives 
that would accomplish our stated objectives, while minimizing any 
significant adverse impact on small entities. In connection with the 
proposed rules and rule amendments, the Commission considered the 
following alternatives: (i) the establishment of differing compliance 
or reporting requirements or timetables that take into account the 
resources available to small entities; (ii) the clarification, 
consolidation, or simplification of compliance and reporting 
requirements under the proposed rules and rule amendments for such 
small entities; (iii) the use of performance rather than design 
standards; and (iv) an exemption from coverage of the proposed rules 
and rule amendments, or any part thereof, for such small entities.
    Regarding the first and fourth alternatives, we do not believe that 
differing compliance or reporting requirements or an exemption from 
coverage of the proposed rules and rule amendments, or any part 
thereof, for small entities, would be appropriate or consistent with 
investor protection. Because the protections of the Advisers Act and 
Exchange Act are intended to apply equally to clients and customers of 
both large and small advisory and brokerage firms, it would be 
inconsistent with the purposes of the Advisers Act and Exchange Act to 
specify different requirements for small entities under the proposed 
rules and rule amendments. We believe there has been, and will continue 
to be, rapid adoption and use of covered technologies in the 
industry,\369\ and that the effects of conflicts of interest associated 
with these covered technologies are contrary to the public interest and 
the protection of

[[Page 54021]]

investors.\370\ Consequently, we believe that investors would receive 
important protections under the proposed conflicts rules and proposed 
recordkeeping amendments and that establishing different conditions for 
large and small firms, when investors use both large and small firms, 
would negate these benefits.
---------------------------------------------------------------------------

    \369\ See supra section I.B.
    \370\ See id.
---------------------------------------------------------------------------

    Regarding the second alternative, the proposed conflicts rules and 
amendments to rule 204-2 and rules 17a-3 and 17a-4 are intended to 
prohibit conduct that the Commission considers to be contrary to the 
public interest and protection of investors under section 211 of the 
Advisers Act and Section 15 of the Exchange Act. We have endeavored to 
consolidate and simplify the compliance requirements under the proposed 
conflicts rules and the proposed amendments to rule 204-2 and 17a-3 and 
17a-4 for all firms, and we do not believe that the goal of the 
proposed conflicts rules and proposed recordkeeping amendments of 
enhancing investor protection would be achieved as well by further 
consolidating or simplifying the requirements. In addition, the 
proposed conflicts rules provide minimum standards for all covered 
technologies, but the elimination and neutralization requirement would 
only affect firms whose use of covered technology is actually 
determined to place the interests of the firm ahead of investors, 
meaning certain aspects of the proposed conflicts rules would only have 
an impact on small entities to the extent that the entities' use of 
covered technologies places their interests ahead of investors.
    Regarding the third alternative, we determined to use a combination 
of performance and design standards. Although the proposed conflicts 
rules would require firms to undertake certain functions relating to 
the elimination or neutralization of the effect of certain conflicts of 
interest and requires firms to adopt, implement, and, in the case of 
broker-dealers, maintain, certain policies and procedures reasonably 
designed to achieve compliance with the requirement to eliminate, or 
neutralize the effect of, certain conflicts of interest,\371\ the 
proposed conflicts rules would allow firms a broad range of flexibility 
in complying with these requirements. For example, as described in 
detail in section II.A.2.e., firms have flexibility in determining 
whether to eliminate a conflict of interest or neutralize the effect of 
the conflict. Similarly, in light of the broad range of covered 
technology and investor interactions, the proposed conflicts rules 
provide firms with flexibility in their evaluation of any use or 
reasonably foreseeable potential use by the firm or its associated 
person of a covered technology and flexibility in their determination 
of whether any such conflict of interest places or results in placing 
the firm's or its associated person's interest ahead of investors' 
interests. We believe that flexibility is appropriate, but also believe 
that certain of the design standards in the proposed conflicts rules 
and proposed recordkeeping amendments are necessary to, among other 
things, facilitate the Commission's examination and enforcement 
capabilities by creating records staff can use to assess compliance 
with the requirements of the proposed conflicts rules, and to help 
facilitate assessment by firm compliance staff of such compliance.
---------------------------------------------------------------------------

    \371\ See supra section II.
---------------------------------------------------------------------------

H. Solicitation of Comments

    We encourage written comments on the matters discussed in this 
IRFA. We solicit comment on the number of small entities subject to the 
proposed conflicts rules and the proposed amendments to rule 204-2 and 
rules 17a-3 and 17a-4, as well as the potential impacts discussed in 
this analysis; and whether the proposal could have an effect on small 
entities that has not been considered. We request that commenters 
describe the nature of any impact on small entities and provide 
empirical data to support the extent of such impact.

VI. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \372\ we must advise OMB whether a proposed 
regulation constitutes a ``major'' rule. Under SBREFA, a rule is 
considered ``major'' where, if adopted, it results in or is likely to 
result in (i) an annual effect on the economy of $100 million or more; 
(ii) a major increase in costs or prices for consumers or individual 
industries; or (iii) significant adverse effects on competition, 
investment or innovation.
---------------------------------------------------------------------------

    \372\ Public Law 104-121, Title II, 110 Stat. 857 (1996) 
(codified in various sections of 5 U.S.C., 15 U.S.C., and as a note 
to 5 U.S.C. 601).
---------------------------------------------------------------------------

    We request comment on the potential impact of the proposed 
conflicts rules and proposed recordkeeping amendments on the economy on 
an annual basis. Commenters are requested to provide empirical data and 
other factual support for their views to the extent possible.

Statutory Authority

    The Commission is proposing new rule 240.151-2 under the Exchange 
Act under the authority set forth in section 15 of the Exchange Act (15 
U.S.C. 78j). The Commission is proposing amendments to Sec. Sec.  
240.17a-3 and 17a-4 under the Exchange Act under the authority set 
forth in section 17 of the Exchange Act (15 U.S.C. 78q).
    The Commission is proposing new rule 211(h)(2)-4 under the Advisers 
Act under the authority set forth in section 211 of the Investment 
Advisers Act (15 U.S.C. 80b-11(a) and (h)). The Commission is proposing 
amendments to rule 204-2 under the Advisers Act under the authority set 
forth in sections 204 and 211 of the Investment Advisers Act (15 U.S.C. 
80b-4 and 80b-11).

List of Subjects in 17 CFR Parts 240 and 275

    Brokers, Reporting and recordkeeping requirements; Securities.

Text of Proposed Rules and Form Amendments

    For the reasons set out in the preamble, the SEC proposes to amend 
title 17, chapter II of the Code of Federal Regulations as follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

0
1. The authority citation for part 240 is amended to read, in part, as 
follows:

    Authority:  15 U.S.C. 77c, 77d, 77g, 77j, 77s, 7 7z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f, 
78g, 78i, 78j, 78j-1, 78j-4, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 
78o-4, 78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll, 
78mm, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, 7201 et 
seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C.5221(e)(3); 18 U.S.C. 
1350; and Pub. L. 111-203, 939A, 124 Stat.1376 (2010); and Pub. L. 
112-106, sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise 
noted
* * * * *
0
2. Add Sec.  240.15l-2 to read as follows:


Sec.  240.15l-2  Prohibition against conflicts associated with investor 
interactions employing covered technology.

    (a) Definitions. For purposes of this section:
    Conflict of interest exists when a broker or dealer uses a covered 
technology that takes into consideration an interest of the broker or 
dealer, or a natural person who is an associated person of a broker or 
dealer.
    Covered technology means an analytical, technological, or 
computational function, algorithm, model, correlation matrix, or 
similar

[[Page 54022]]

method or process that optimizes for, predicts, guides, forecasts, or 
directs investment-related behaviors or outcomes.
    Investor means a natural person, or the legal representative of 
such natural person, who seeks to receive or receives services 
primarily for personal, family or household purposes.
    Investor interaction means 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; except that the term does not apply to interactions solely 
for purposes of meeting legal or regulatory obligations or providing 
clerical, ministerial, or general administrative support.
    (b) Elimination or neutralization of the effect of conflicts of 
interest. A broker or dealer must:
    (1) Evaluate any use or reasonably foreseeable potential use of a 
covered technology by the broker or dealer, or a natural person who is 
an associated person of a broker or dealer, in any investor interaction 
to identify any conflict of interest associated with that use or 
potential use (including by testing each such covered technology prior 
to its implementation or material modification, and periodically 
thereafter, to determine whether the use of such covered technology is 
associated with a conflict of interest);
    (2) Determine if any conflict of interest identified pursuant to 
paragraph (b)(1) of this section places or results in placing the 
interest of the broker or dealer, or a natural person who is an 
associated person of a broker or dealer ahead of the interests of 
investors; and
    (3) Eliminate, or neutralize the effect of, any conflict of 
interest (other than conflicts of interest that exist solely because 
the broker or dealer seeks to open a new investor account) determined 
pursuant to paragraph (b)(2) of this section to result in an investor 
interaction that places the interest of the broker or dealer, or a 
natural person who is an associated person of a broker or dealer, ahead 
of the interests of investors, promptly after the broker or dealer 
determines, or reasonably should have determined, that the conflict of 
interest placed the interests of the broker or dealer, or a natural 
person who is an associated person of a broker or dealer, ahead of the 
interests of investors.
    (c) Policies and procedures. A broker or dealer that is subject to 
paragraph (b) of this section and that has any investor interaction 
using covered technology must adopt, implement, and maintain written 
policies and procedures reasonably designed to achieve compliance with 
paragraph (b) of this section, including:
    (1) A written description of the process for evaluating any use or 
reasonably foreseeable potential use of a covered technology in any 
investor interaction pursuant to paragraph (b)(1) of this section and a 
written description of any material features of, including any 
conflicts of interest associated with the use of, any covered 
technology used in any investor interaction prior to such covered 
technology's implementation or material modification, which must be 
updated periodically;
    (2) A written description of the process for determining whether 
any conflict of interest identified pursuant to paragraph (b)(1) of 
this section results in an investor interaction that places the 
interest of the broker or dealer, or a natural person who is an 
associated person of a broker or dealer ahead of the interests of 
investors;
    (3) A written description of the process for determining how to 
eliminate, or neutralize the effect of, any conflicts of interest 
determined pursuant to paragraph (b)(2) of this section to result in an 
investor interaction that places the interest of the broker or dealer 
or a natural person who is an associated person of a broker or dealer 
ahead of the interests of investors; and
    (4) A review and written documentation of that review, no less 
frequently than annually, of the adequacy of the policies and 
procedures established pursuant to this section and the effectiveness 
of their implementation as well as a review of the written descriptions 
established pursuant to this section.
0
3. Amend Sec.  240.17a-3 by adding paragraph (a)(36) to read as 
follows:


Sec.  240.17a-3  Records to be made by certain exchange members, 
brokers and dealers.

* * * * *
    (a) * * *
* * * * *
    (36) All records required to be made and maintained pursuant to 
Sec.  240.15l-2, including:
    (i) Written documentation of the evaluation conducted pursuant to 
Sec.  240.15l-2(b)(1), including:
    (A) A list or other record of all covered technologies used in 
investor interactions by the broker or dealer, including:
    (1) The date on which each covered technology is first implemented, 
and each date on which any covered technology is materially modified; 
and
    (2) The broker or dealer's evaluation of the intended as compared 
to the actual use and outcome of each covered technology in investor 
interactions.
    (B) Documentation describing any testing of the covered technology 
in accordance with Sec.  240.15l-2(b)(1), including:
    (1) The date on which testing was completed;
    (2) The methods used to conduct the testing;
    (3) Any actual or reasonably foreseeable potential conflicts of 
interest identified as a result of the testing;
    (4) A description of any changes or modifications to the covered 
technology made as a result of the testing and the reason for those 
changes; and
    (5) Any restrictions placed on the broker or dealer's use of the 
covered technology as a result of the testing.
    (ii) Written documentation of each determination made pursuant to 
Sec.  240.15l-2(b)(2), including the rationale for such determination.
    (iii) Written documentation of each elimination or neutralization 
made pursuant to Sec.  240.15l-2(b)(3).
    (iv) The written policies and procedures prepared in accordance 
with Sec.  240.15l-2(c), including any written description and the date 
on which the policies and procedures were last reviewed.
    (v) A record of any disclosures provided to each investor regarding 
the broker or dealer's use of covered technologies, including, if 
applicable, the date such disclosure was provided or updated.
    (vi) A record of each instance in which a covered technology was 
altered, overridden, or disabled, the reason for such action, and the 
date thereof, including a record of all instances where an investor 
requested that a covered technology be altered or restricted in any 
manner.
    (vii) For the purposes of this paragraph, the terms covered 
technology, investor, investor interaction, and conflict of interest 
have the same meanings as set forth in Sec.  240.15l-2.
0
4. Amend Sec.  240.17a-4 by amending paragraph (a) to read as follows:


Sec.  240.17a-4  Records to be preserved by certain exchange members, 
brokers and dealers.

* * * * *
    (a) Every member, broker or dealer subject to Sec.  240.17a-3 must 
preserve for a period of not less than six years, the first two years 
in an easily accessible place, all records required to be made pursuant 
to Sec.  240.17a-3(a)(1) through (3), (5), (21), (22), and (36) and 
analogous records created pursuant to Sec.  240.17a-3(e).
* * * * *

[[Page 54023]]

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

0
5. The authority citation for part 275 continues to read, in part, as 
follows:

    Authority:  15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless 
otherwise noted.
* * * * *
    Section 275.204-2 is also issued under 15 U.S.C. 80b-6.
* * * * *
0
6. Amend Sec.  275.204-2 by:
0
a. Adding and reserving paragraphs (a)(20) through (23); and
0
b. Adding paragraph (a)(24).
    The addition reads as follows:


Sec.  275.204-2   Books and records to be maintained by investment 
advisers.

    (a) * * *
    (20)-(23) [Reserved]
    (24) All records required to be made and maintained pursuant to 
Sec.  275.211(h)(2)-4, including:
    (i) Written documentation of the evaluation conducted pursuant to 
Sec.  275.211(h)(2)-4(b)(1), including:
    (A) A list or other record of all covered technologies used in 
investor interactions by the investment adviser, including:
    (1) The date on which each covered technology is first implemented, 
and each date on which any covered technology is materially modified; 
and
    (2) The investment adviser's evaluation of the intended as compared 
to the actual use and outcome of each covered technology in investor 
interactions.
    (B) Documentation describing any testing of the covered technology 
in accordance with Sec.  275.211(h)(2)-4(b)(1), including:
    (1) The date on which testing was completed;
    (2) The methods used to conduct the testing;
    (3) Any actual or reasonably foreseeable potential conflicts of 
interest identified as a result of the testing;
    (4) A description of any changes or modifications to the covered 
technology made as a result of the testing and the reason for those 
changes; and
    (5) Any restrictions placed on the investment adviser's use of the 
covered technology as a result of the testing.
    (ii) Written documentation of each determination made pursuant to 
Sec.  275.211(h)(2)-4(b)(2), including the rationale for such 
determination.
    (iii) Written documentation of each elimination or neutralization 
made pursuant to Sec.  275.211(h)(2)-4(b)(3).
    (iv) The written policies and procedures prepared in accordance 
with Sec.  275.211(h)(2)-4(c), including any written description and 
the date on which the policies and procedures were last reviewed.
    (v) A record of any disclosures provided to each investor regarding 
the investment adviser's use of covered technologies, including, if 
applicable, the date such disclosure was provided or updated.
    (vi) A record of each instance in which a covered technology was 
altered, overridden, or disabled, the reason for such action, and the 
date thereof, including a record of all instances where an investor 
requested that a covered technology be altered or restricted in any 
manner.
    (vii) For the purposes of this paragraph, the terms covered 
technology, investor, investor interaction, and conflict of interest 
have the same meanings as set forth in Sec.  275.211(h)(2)-4.
0
7. Add Sec.  275.211(h)(2)-4 to read as follows:


Sec.  275.211(h)(2)-4  Prohibition against conflicts associated with 
investor interactions employing covered technology.

    (a) Definitions. For purposes of this section:
    Conflict of interest exists when an investment adviser uses a 
covered technology that takes into consideration an interest of the 
investment adviser, or a natural person who is a person associated with 
the investment adviser.
    Covered technology means an analytical, technological, or 
computational function, algorithm, model, correlation matrix, or 
similar method or process that optimizes for, predicts, guides, 
forecasts, or directs investment-related behaviors or outcomes.
    Investor means any prospective or current client of an investment 
adviser or any prospective or current investor in a pooled investment 
vehicle (as defined in Sec.  275.206(4)-8) advised by the investment 
adviser.
    Investor interaction means 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; except that the term does not apply to interactions solely 
for purposes of meeting legal or regulatory obligations or providing 
clerical, ministerial, or general administrative support.
    (b) Elimination or neutralization of the effect of conflicts of 
interest. An investment adviser that is registered or required to be 
registered under section 203 of the Act must:
    (1) Evaluate any use or reasonably foreseeable potential use of a 
covered technology by the investment adviser, or a natural person who 
is a person associated with the investment adviser, in any investor 
interaction to identify any conflict of interest associated with that 
use or potential use (including by testing each such covered technology 
prior to its implementation or material modification, and periodically 
thereafter, to determine whether the use of such covered technology is 
associated with a conflict of interest);
    (2) Determine if any conflict of interest identified pursuant to 
paragraph (b)(1) of this section places or results in placing the 
interest of the investment adviser, or a natural person who is a person 
associated with the investment adviser, ahead of the interests of 
investors; and
    (3) Eliminate, or neutralize the effect of, any conflict of 
interest (other than conflicts of interest that exist solely because 
the investment adviser seeks to open a new client account) determined 
pursuant to paragraph (b)(2) of this section to result in an investor 
interaction that places the interest of the investment adviser, or a 
natural person who is a person associated with the investment adviser, 
ahead of the interests of investors, promptly after the investment 
adviser determines, or reasonably should have determined, that the 
conflict of interest placed the interests of the investment adviser, or 
a natural person who is a person associated with the investment 
adviser, ahead of the interests of investors.
    (c) Policies and procedures. An investment adviser that is subject 
to paragraph (b) of this section and that has any investor interaction 
using covered technology must adopt and implement written policies and 
procedures reasonably designed to prevent violations of paragraph (b) 
of this section, including:
    (1) A written description of the process for evaluating any use or 
reasonably foreseeable potential use of a covered technology in any 
investor interaction pursuant to paragraph (b)(1) of this section and a 
written description of any material features of, including any 
conflicts of interest associated with the use of, any covered 
technology used in any investor interaction prior to such covered 
technology's implementation or material modification, which must be 
updated periodically;
    (2) A written description of the process for determining whether 
any conflict of interest identified pursuant to paragraph (b)(1) of 
this section results in an investor interaction that places the 
interest of the investment adviser or a natural person who is a person

[[Page 54024]]

associated with the investment adviser ahead of the interests of 
investors;
    (3) A written description of the process for determining how to 
eliminate, or neutralize the effect of, any conflicts of interest 
determined pursuant to paragraph (b)(2) of this section to result in an 
investor interaction that places the interest of the investment adviser 
or natural person who is a person associated with the investment 
adviser ahead of the interests of investors; and
    (4) A review and written documentation of that review, no less 
frequently than annually, of the adequacy of the policies and 
procedures established pursuant to this section and the effectiveness 
of their implementation as well as a review of the written descriptions 
established pursuant to this section.

    By the Commission.

    Dated: July 26, 2023.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2023-16377 Filed 8-8-23; 8:45 am]
BILLING CODE 8011-01-P

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