Amy Caiazza
Cutting-edge technology, from machine learning and AI to new payment rails, is transforming the world of financial services, including how fintech startups manage investor assets, assess the suitability of investments, and execute transactions.
However, recent attempts by the Securities and Exchange Commission to broaden its definition of fiduciary duties for investment advisers and the obligation of broker-dealers to act in customers’ best interest could create significant regulatory risks for those startups. This change is apparent in recently proposed rules that would sharply curtail the use of artificial intelligence and other technologies by broker-dealers and investment advisers.
A history of investment advisers’ fiduciary duties
Investment advisers have long been viewed as fiduciaries to their clients. Although the Investment Advisers Act of 1940 (the primary federal law regulating investment advisers) does not explicitly impose fiduciary duties on advisers, in 1963’s SEC v. Capital Gains, the Supreme Court found the law fundamentally based on the idea that advisers are fiduciaries.
In that case, the Court focused solely on whether the SEC could insist an adviser disclose practices raising conflicts of interest. While the Court acknowledged a separate argument that the potential conflicts of interest involved in the case should be eliminated rather than merely disclosed, the Court declined to rule on that issue, noting that the SEC had limited its request to disclosure — even though the conflict of interest in the case was significant.
Expansion in recent guidance
Over 50 years later, in 2019, the SEC issued an interpretive release asserting a much more expansive view of an adviser’s fiduciary duties. This standard encompasses a duty of care — which involves the duty to provide advice that is in the best interest of the client, to seek the best execution of a client’s transactions, and to provide advice and monitoring throughout the relationship — and a duty of loyalty, which involves either eliminating or providing full and fair disclosure of conflicts of interest.
A critical assertion in the SEC’s discussion was that, in some cases, conflicts may be so significant and impactful that they cannot be fully and fairly disclosed, and in those cases, the SEC believed that an adviser should either eliminate the conflict or modify practices enough that full and fair disclosure and informed consent are possible.
Regulation Best Interest for broker-dealers
Broker-dealers are technically not fiduciaries to their customers under the main federal law regulating their activity — the Securities Exchange Act of 1934. But Congress, in passing the Dodd-Frank Wall Street Reform and Consumer Protection Act, gave the SEC the authority to impose a fiduciary obligation on broker-dealers.
Although the SEC has stopped short of doing that, in 2019, it adopted Regulation Best Interest (Reg BI), which requires that when a broker-dealer makes a recommendation to a retail customer, it must act in the best interest of the customer at the time the recommendation is made, without placing the broker-dealer’s financial or other interest ahead of the customer’s. The scope of these obligations is similar to those that apply based on an investment adviser’s fiduciary duties.
Application to predictive data
Earlier this year, the SEC proposed rules on using predictive data (e.g., artificial intelligence) by advisers and broker-dealers. These rules assert that the conflicts involved with predictive data are inherently too complex and unpredictable for disclosure to be sufficient. As a result, the rule would require that an adviser or broker eliminate or neutralize the effects of a conflict.
The SEC’s analysis is an unprecedented application of the standards for advisers and broker-dealers: It represents a bright-line rule that precludes disclosure as a way to meet an adviser’s or broker’s obligations where the adviser or broker uses predictive data technology, regardless of the scope, seriousness, and knowability of the conflicts involved. Instead, the adviser or broker must thoroughly eliminate those conflicts, no matter their gravity or potential impact.
Notably, the technology covered by the rules includes any “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.” This, seemingly, could encompass something as simple as an Excel spreadsheet.
Hidden costs of the SEC’s approach
The SEC’s proposed rules and any similar attempts to broaden the concept of adviser and broker fiduciary (or fiduciary-like) obligations to customers could be gating to fintech startups hoping to enter the asset management or brokerage space by providing innovative technologies.
The rules, if adopted, could require that startups invest significantly more time and money into their compliance programs and carefully structure their processes for identifying and addressing potential conflicts of interest.
In addition, the SEC’s expanded sense of adviser and broker obligations raises questions regarding when other complex products and technologies may fall into the scope of cases where disclosure is insufficient. This creates a significant uncertainty as to how brokers and advisers can best comply with their obligations, which in turn ratchets up the regulatory risk associated with providing advisory or brokerage services.
Investment advisers who seek to innovate will need to tread carefully in this space to avoid missteps, which could have significant consequences for their viability and legal and regulatory status.
(Disclosure: The views expressed in this article reflect those of the author and do not necessarily reflect the views of her employer and its clients.)
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