The U.S. Securities and Exchange Commission (“SEC”) has proposed Rule 211(h)(2)-4 which requires an investment adviser registered with the SEC to address conflicts of interest that arise from the use of covered technologies which optimize, predict, guide, forecasts, or directs investment-related behaviors or outcomes.
Covered Technology: The term “covered technology” in the proposed rule refers to any algorithm, computational tool, or technology that uses data analysis, predictive modeling, or machine learning to guide or influence investment-related behaviors or outcomes. Examples of covered technology include algorithmic-based tools used to provide tailored investment recommendations, financial modeling tools contained in spreadsheets, and large language models used in investor interactions.
Evaluation of Conflicts of Interest: An investment adviser must evaluate any use or potential use of a covered technology to identify any conflict of interest associated with that use.
Determination of Conflicts of Interest: If a conflict of interest is identified, the investment adviser must determine whether this conflict places the adviser’s interest ahead of the interest of clients.
Elimination or Neutralization of Conflicts of Interest: If the covered technology results in the investment adviser’s interest being placed ahead of the client’s interest, the investment adviser must eliminate this conflict of interest or mitigate its effect.
Policies and Procedures: An investment adviser is required to adopt, implement, and maintain written policies and procedures designed to ensure compliance with the rule if adopted. These policies and procedures should include a review, no less frequently than annually, of the adequacy of the policies and procedures and the effectiveness of their implementation.
Recordkeeping Requirements: Under the SEC’s proposed rule, investment advisers must maintain the following for at least 5 years, with the first two years in an easily accessible place:
- Documentation of evaluations identifying conflicts of interest with the use of covered technology;
- Documentation of determinations if these conflicts place the adviser’s interest ahead of investors;
- Documentation of actions taken to eliminate or neutralize such conflicts;
- Written policies and procedures for compliance with the proposed rules;
- Annual reviews of the adequacy and effectiveness of these policies and procedures; and
- List of all covered technologies used by investment adviser including when first used;
- Records of alterations, overrides, or disabling of covered technology, including reasons and dates.
This proposed rule is a significant development for SEC registered investment advisers who use predictive data analytics or artificial intelligence. It underscores the importance of identifying and addressing conflicts of interest within the covered technology. Investment advisers must remain vigilant and adapt their practices to comply with regulatory requirements as technology evolves.
Link to Proposed Rule
The proposed rule release is available at the following webpage: https://www.sec.gov/files/rules/proposed/2023/34-97990.pdf
The SEC is inviting comments on these proposed changes. Interested parties can submit their comments within 60 days following the publication of the proposing release in the Federal Register. To make a comment, visit the SEC’s Rulemaking Activity webpage at https://www.sec.gov/rules/rulemaking-activity and click on the proposed rule.
If you are an investment adviser firm would like assistance reviewing your technology for conflicts of interest or best practices related to artificial intelligence, RIA Compliance Consultants can be engaged for a consultation. If you are an existing client of RIA Compliance Consultants, please contact your consultant. If you are a prospective client, please feel free to contact our Business Development Team at 877-345-4034 or using our online calendar at https://www.ria-compliance-consultants.com/schedule-introductory-call/ .
This Regulatory Watch is a brief summary which is general in nature and offered only for educational purposes. It should not be considered as a comprehensive review or analysis of this proposal. This communication is not intended to constitute compliance consulting advice or apply to any particular investment adviser firm’s specific situation without further analysis. This post is not a safe harbor or a legal opinion. The reader should study the proposed rule referenced in this Regulatory Watch (and if approved, the final rule) in detail and consult with his or her compliance professionals. The information in this Regulatory Watch will not necessarily be updated to reflect the most current activity related to the proposed rule.