In an era characterized by the rapid advancement of predictive data analytics and artificial intelligence (AI), regulatory bodies are stepping up to ensure that investors’ interests are adequately protected. On July 26, 2023, the U.S. Securities and Exchange Commission (SEC) announced a groundbreaking proposal that aims to address potential conflicts of interest arising from the use of AI and predictive data analytics at brokerage and investment advisory firms.
What is the SEC’s proposed AI rule?
The heart of the SEC’s proposal revolves around addressing conflicts of interest that may arise due to the use of AI and predictive data analytics by broker-dealers and investment advisers. SEC Chair Gary Gensler highlighted the significance of the proposal, stating, “When offering advice or recommendations, firms are obligated to eliminate or otherwise address any conflicts of interest and not put their own interests ahead of their investors’ interests. I believe that, if adopted, these rules would help protect investors from conflicts of interest — and require that, regardless of the technology used, firms meet their obligations not to place their own interests ahead of investors’ interests.”
The proposal requires brokerage and investment advisory firms to take proactive steps to evaluate and mitigate conflicts of interest associated with their use of AI and predictive data analytics. This involves determining whether their firms’ interests are placed ahead of investors’ interests due to the technology’s application. If such conflicts are identified, the firms are obligated to eliminate or neutralize their effects.
Best practices for investment advisory firms when implementing AI
While the SEC’s proposed rule aims to set a regulatory framework for ensuring investor protection, investment advisory firms can adopt certain best practices to not only meet the proposed requirements but also enhance their operational transparency and ethical practices. It’s also worth noting that while this is a proposed rule, given the increasing use of AI in the financial services industry, it’s likely that regulations related to AI will eventually go into effect in some capacity and that these best practices will still be useful to implement.
The SEC recently conducted an examination to identify gaps in an investment advisory firm’s compliance program related to its use of AI. These best practices were gleaned from that examination. Investment advisory firms that implement AI should adopt:
- Robust disclosure practices.
Investment advisory firms should provide clear and comprehensive disclosure documents to clients, explicitly stating the use of AI and predictive data analytics in their operations. Transparency helps clients make informed decisions and builds trust.
2. Enhanced compliance policies and procedures.
Firms should establish and maintain written compliance and operational policies that outline how AI systems are supervised, operated and managed. Regularly updating these policies to address changes in technology or business practices is crucial.
3. Employee training and education.
Providing ongoing compliance training to employees involved in developing, implementing, supervising or using AI software systems is essential. Ensuring that employees understand their responsibilities in adhering to ethical and legal standards will mitigate potential conflicts of interest.
4.Committees for oversight.
Setting up committees specifically responsible for AI-related matters can facilitate effective oversight. These committees should meet regularly, maintain written minutes and include representatives from various relevant departments.
5. Thorough algorithmic documentation.
Firms should document detailed descriptions of all AI-based algorithmic models used to manage client portfolios. This documentation should also encompass the methods employed, comparison studies and adjustments made due to data acquisition errors.
6. Transparent data source management.
Maintain an updated list of data sources used by AI systems, along with their acquisition methods. Clearly outline how both contracted and in-house data sources are obtained and managed. This aids in risk management and maintaining accountability.
7. Regular audits and reviews.
Conduct periodic audits and reviews of AI models and trading signals to identify and rectify any potential conflicts of interest or biases. Ensure adjustments made are well-documented and transparent.
8. Ethical considerations and investor impact.
Consider the ethical implications of AI decisions and the potential impact on investors. Establish a framework to assess whether AI-driven recommendations prioritize investor interests.
The SEC’s proposed rule represents a significant step toward aligning technological advancements with investor protection. As investment advisory firms continue to embrace AI and predictive data analytics, it is imperative that they adhere to the proposed guidelines and implement best practices that prioritize investors’ interests. By adopting transparent and ethical practices, RIA firms can navigate the evolving landscape of AI in finance while safeguarding the trust and well-being of their clients.
Considering the rapid changes in the regulatory landscape, now is the time to lean into your resources and away from potential violations. Learn more about the COMPLY consulting services and solutions, and how we can help your firm prepare for these changes, update your policies and procedures and more!