Conflicts of Interest Associated With the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers, 53960-54024 [2023-16377]
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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.
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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
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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].
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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
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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
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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).
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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
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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
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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
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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://
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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).
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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
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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
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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
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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-
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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.
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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.’’);
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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
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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
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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
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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.
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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,
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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.
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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.’’).
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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?’’).
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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.
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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.
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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
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.
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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).
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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.
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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
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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’’).
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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.’’).
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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.
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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 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
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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).
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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.
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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.
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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
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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).
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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.
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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.
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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
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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
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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
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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).
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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)].
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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
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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).
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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
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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.
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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?
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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?
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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
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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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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).
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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.
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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).
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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).
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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.
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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
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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.
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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
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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
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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?
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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.
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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.
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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/.
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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
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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
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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
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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.
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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.
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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
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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
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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
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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
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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.
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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.
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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
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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.
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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
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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
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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.
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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,
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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.’’).
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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.
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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.
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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
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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.
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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).
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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,
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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
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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
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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).
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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?
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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
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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).
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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’’).
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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
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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
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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
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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).
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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.
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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
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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
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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
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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
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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?
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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.
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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.
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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
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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
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FINRA Rule 3110(b)(1).
211 Municipal Securities Rulemaking Board.
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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.
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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).
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(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
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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).
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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
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226 Proposed 17 CFR 240.17a–3(e)(36)(vi); 17 CFR
275.204–2(a)(24)(vi).
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227 15
228 15
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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).
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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
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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’’).
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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).
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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
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.
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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.
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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 .............................................................................................
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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).
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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/.
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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
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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.
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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.
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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
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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.
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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).
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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
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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.
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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.
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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.
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
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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.
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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
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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
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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
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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.
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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).
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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
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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
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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).
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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
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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
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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:
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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.
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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
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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.
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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
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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.
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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.
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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
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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.
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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
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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
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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
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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.
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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.
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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
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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.
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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.
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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
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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.
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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.
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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,
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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
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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
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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.
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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
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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.
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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
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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
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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.
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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
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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.
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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.
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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
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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
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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
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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
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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
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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.
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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.
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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.
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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
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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
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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).
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‘‘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
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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
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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.
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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
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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
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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
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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).
*
*
*
*
*
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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:
■
■
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§ 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
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§ 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
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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
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Federal Register / Vol. 88, No. 152 / Wednesday, August 9, 2023 / Proposed Rules
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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
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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
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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
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Agencies
[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\
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\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.
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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.
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\5\ See infra section III.C.3.
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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.
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\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.
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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.
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\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.
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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\
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\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).
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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\
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\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.'').
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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.
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\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.
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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.
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\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).
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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.
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\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'').
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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\
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\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.
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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/.
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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'').
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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.
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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\
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\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.'').
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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\
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\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)'').
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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.
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\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.'').
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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.
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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).
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\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.
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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\
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\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\
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\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'').
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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.
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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.
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\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.
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\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).
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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)].
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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).
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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.
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\154\ See infra section II.A.2.e for additional information
regarding drift.
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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.
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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.
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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.
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\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.
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\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.
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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.
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\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\
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\162\ See infra section II.A.2.e.
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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).
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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.
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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.
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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\
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\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.
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\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.
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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).
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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.
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\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.
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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.
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\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'').
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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.
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\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.'').
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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\
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\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.
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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.
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\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.
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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.
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\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.
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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.
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\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).
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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).
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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'').
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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).
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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).
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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\
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\203\ See supra section II.A.2.a (discussion on Evaluation and
Identification).
\204\ See id.
\205\ See id.
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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.
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\206\ Proposed conflicts rules at (c)(2).
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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.
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\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.
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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).
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\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.
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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.
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\209\ Proposed conflicts rules at (c)(4).
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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.
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\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.
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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.
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\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.''
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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.
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\214\ See id.
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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.
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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).
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\219\ Proposed 17 CFR 240.17a-3(e)(36)(ii); 17 CFR 275.204-
2(a)(24)(ii).
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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).
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\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).
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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.
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\222\ Proposed 17 CFR 240.17a-3(e)(36)(iv); 17 CFR 275.204-
2(a)(24)(iv).
\223\ See id.
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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\
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\224\ See id.
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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.
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\225\ Proposed 17 CFR 240.17a-3(e)(36)(v); 17 CFR 275.204-
2(a)(24)(v).
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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.
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\226\ Proposed 17 CFR 240.17a-3(e)(36)(vi); 17 CFR 275.204-
2(a)(24)(vi).
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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.
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\227\ 15 U.S.C. 78c(f).
\228\ 15 U.S.C. 80b-2(c).
\229\ 15 U.S.C. 78w(a)(2).
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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.
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\230\ See supra section I.B.
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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.
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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).
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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.
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\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.
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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\
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\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.
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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.
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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.
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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/.
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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.
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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.
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\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.
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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.
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\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.
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\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.'').
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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.
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\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.
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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\
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\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).
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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\
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\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.
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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\
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\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).
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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\
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\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).
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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\
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\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).
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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\
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\314\ See supra note 212 (citing FINRA Rule 3130(b)).
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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.
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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.
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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.
---------------------------------------------------------------------------
\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.
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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.
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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.
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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\
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\328\ See infra section IV.B.
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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\
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\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.
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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.
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\335\ The proposed conflicts rules do not prohibit such third-
party analyses.
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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.
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\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.
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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\
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\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
technolo