SEC Moves Forward to Regulate Use of AI by Broker-Dealers and Investment Advisers | Manatt, Phelps & Phillips, LLP

Applications of AI

The Securities and Exchange Commission (SEC) held a public meeting of its Investment Advisory Committee on June 6, 2024, and convened a panel to examine the use of artificial intelligence in investment decision-making.

In July 2023, the SEC proposed new rules.1 To address conflicts of interest related to broker-dealers and investment advisers' use of predictive data analytics (PDA) in their interactions with investors. The proposal calls for:

  • Eliminate or neutralize the impact of conflicts of interest associated with the use of the Covered Technology in interactions with investors.
  • A written policy for companies that use covered technology in their interactions with investors.
  • Record keeping that respects competition rules.

At the June 6 meeting,2 Panelists from SEC staff, academia, the legal community, and industry discussed whether any action should be taken regarding the proposed regulations and whether they go too far or not in protecting investors.

Technologies covered by the new rules include a firm's use of analytical, technological, or computational capabilities, algorithms, models, correction matrices, or similar methods that optimize, predict, guide, forecast, or direct investment-related actions. This definition is broad enough to cover both traditional and generative AI.

In the regulated investment industry, there is understandable skepticism that computers will replace the advisory and brokerage services that humans are licensed, tested and continually evaluated for. Part of that may be the delusion of people who have watched too many robot movies in which robots rise to power and take over.3 But the reality is that most companies are using AI to make certain tasks easier and more efficient, and the SEC is concerned that the essential human element of a qualified professional is being ceded to untested and largely unaccountable computer algorithms.

The SEC wrote: “We believe the current regulatory framework needs to be updated to allow companies to adequately address conflicts of interest associated with the use of technologies like PDAs. As a result, we are proposing certain protections that would complement those already required in the existing regulatory framework to better protect investors from harms resulting from these conflicts.” The SEC continues: “While conflicts of interest between companies and investors are not new, companies' increasing use of these PDA-like technologies in their interactions with investors may expose investors to unique risks, including the risk that conflicts of interest will not be identified and addressed, or will be identified but not addressed. The impact of such unaddressed conflicts of interest could be pernicious, particularly because the technology can rapidly propagate or amplify conflicting conduct throughout a company's investor base.”

Under the SEC's proposed rule, firms using PDAs would be required to adopt policies to identify and neutralize potential conflicts of interest for investors. Use of PDAs would be in the context of interacting with investors, i.e., communicating, exercising discretion with respect to investor accounts, soliciting or informing investors. A conflict of interest generally refers to any function that places the needs or best interests of investors above the needs or interests of the firm. Conflicts of interest include, but are not limited to, (i) excessive trading, (ii) use of trading strategies that involve additional risk (such as options or margin trading), and (iii) trading in complex securities products that are profitable for the firm but pose excessive risk to the issuer.Four

Companies are required to assess, disclose and neutralize their conflicts of interest.Five For example, if a PDA program is recommending excessive trading, a qualified professional should prevent such trading from being executed. If an AI-driven customer service system prevents customers from contacting company employees, the system should be modified or shut down.

Panelists on June 6 largely supported the proposed PDA conflict of interest rules, with some pointing out that it would be impossible to isolate all of a firm's use of AI, but that it is the firm's responsibility as a client fiduciary under the Investment Advisers Act of 1940, or the suitability and best interest rules that apply to broker-dealers.6 Others noted that companies and their experts must not succumb to the temptation to use efficient PDAs and AI-driven strategies that eliminate the necessary human element of communicating with customers and ensuring that recommendations are in their best interest.

Notably, the CFTC requested public comment in January 2024 on the use of AI in its regulated markets.7 The CFTC sought comment on its definition of AI and its applications, including its use in trading, risk management, compliance, cybersecurity, recordkeeping, data processing and analysis, and customer interactions. It also sought comment on the risks of AI, including risks related to market manipulation and fraud, governance, explainability, data quality, concentration, bias, privacy and confidentiality, and customer protection. The CFTC did not propose any new rules, and may not do so depending on the outcome of the comment process.

As with all agencies involved in regulating AI, the technology and its applications will advance rapidly, and regulators will be careful not to stifle innovation or introduce rules that will be forgotten or become irrelevant soon after being passed.

1 | SEC Proposes New Requirements to Address Investor Risks from Conflicts of Interest Related to Broker-Dealers and Investment Advisers’ Use of Predictive Data Analytics and

2 For the agenda and webcast, please visit

3 See, for example, The Matrix trilogy, Terminator Salvation, I, Robot, Oblivion, and many others.

4 See page 28 of

5 The mitigation requirements differ from the disclosure regime for corporate finance issuers, which is primarily based on the disclosure of conflicts of interest or related party transactions. See 17 CFR § 229.404 – (Item 404) Related Persons, Promoters, and Certain Controlled Person Transactions | Electronic Code of Federal Regulations (e-CFR) | United States Law | LII / Legal Information Institute ( and

6 See

7 See,and%20confidentiality%20and%20customer%20protection.

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