SEC Proposes New Requirements to Address Risks to Investors From Conflicts of Interest Associated With the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers

In view of rapid technology advancements and the deployment of such by financial market participants, the U.S. Securities and Exchange Commission (SEC) has published a press statement to announce an upcoming consultation in connection with the use of Predictive Data Analytics (PDA) by broker-dealers and investment advisers. Specifically, the SEC seeks to establish separate rules concerning the monitoring, mitigation, and prevention of conflicts of interest when using PDA in their dealing with clients. Naturally, the key aim of the Commission is to protect investors from the potential use of PDA that could benefit broker-dealers to the detriment of their clients (for example, via „guiding investors“ towards high risk investments by using analytical data about their investment behavior to design their websites so as to encourage high risk investing).
According to the enclosed draft, PDA – or „covered technology“ – would be defined 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“. The proposed rules would encompass requirements as to the elimination or neutralization of any such conflicts of interest, the maintenance of policies and procedures to ensure compliance with such requirements, and associated recordkeeping obligations. The key elements of the draft rules are briefly described below:
(1) Elimination or neutralization of conflicts of interest:
Brokers or dealers would be required to assess the current or potential use of covered technology in investor interactions. This evaluation would aim to identify any conflicts of interest associated with the use or potential use of such technology. The evaluation should include testing of the covered technology before implementation or significant modification, and periodic assessments thereafter. If conflicts of interest are identified (as per the evaluation in point 1), brokers or dealers would have to determine whether these conflicts of interest lead to situations where the broker’s or dealer’s interests, or those of associated individuals, are prioritized over the interests of investors. If a conflict of interest is found to place the interests of the broker or dealer ahead of those of investors, the broker or dealer would have to take prompt steps to eliminate or neutralize the effect of that conflict of interest.
(2) Introduction of policies and procedures:
Brokers or dealers subject to the above requirements would have to establish written policies and procedures to ensure compliance with the conflict of interest rules outlined in (1). These policies and procedures would have to cover:
– the documentation of the process of evaluating the use or potential use of covered technology in investor interactions. This includes describing any significant features of the technology and any conflicts of interest associated with its use. This information would have to be updated periodically.
– the documentation of a procedure for determining whether conflicts of interest identified in the evaluation process actually result in situations where the broker’s or dealer’s interests are placed ahead of investors‘ interests.
– the documentation of the steps to eliminate or neutralize the effects of conflicts of interest found to prioritize the broker’s or dealer’s interests over those of investors.
Furthermore, these policies and procedures would have to be re-evaluated on an annual basis as to their effectiveness and adequacy. The written descriptions of the processes should also be reviewed as part of this process.
(3) Retention of records:
Finally, the new rules would require certain members of national securities exchanges, brokers, and dealers to create and maintain specific records as to the use of covered technologies in investor interactions. The records would have to be kept for a minimum period of six years and include, among others:
– a list of deployed PDA (must be created right at the beginning of such use);
– any changes to the PDA or its use;
– the evaluation processes described above;
– specifics to conducted testing of the covered technology (date of testing, methods of testing, identified conflicts of interest); or
– the disclosures made to investors about a firm’s use of PDA.