Mindboggling isn’t a word often used when discussing proposals issued by the US Securities and Exchange Commission, but the latest one for registered investment advisers and broker-dealers about addressing conflicts of interest when using predictive data analytics (PDA) and PDA-like technology appears to be a notable exception.
If adopted as drafted, the SEC’s requirement would be unfeasible to follow, say legal and other experts. The regulatory agency has taken a broad interpretation of the technology, the definition of conflict of interest, the type of investor, and the type of communication affected. It won’t be enough to disclose a conflict of interest or mitigate it. Investment advisers and broker-dealers will have to neutralize or eliminate the conflict which could mean eliminating the technology they use altogether. “There is so much that is wrong with the proposal that I wouldn’t know where to begin,” Elliot Ganz, director of advocacy for the Loan Syndications and Trading Association tells FinOps Report. “Unlike previous proposals where we could offer recommendations for change, this proposal needs to be withdrawn.”
In their letter to the SEC, the LSTA and other trade groups say that because of the regulatory agency’s definition of technology and investor interaction covered the SEC has overstepped its reach. “If Congress had intended to give the Commission the authority to regulate any activity of a broker-dealer or adviser outside of the standards of conduct when providing recommendations or investment advice to investors, it would have explicitly granted this authority,” write the LSTA and other trade groups, including the Investment Management Institute, Managed Funds Association, Alternative Investment Management Association, and National Society of Compliance Professionals. The SEC published its proposal in the Federal Register on August 9 and comments are due by October 10.
The SEC presumes that investment advisers and broker-dealers are using PDA and PDA-like technologies to benefit themselves at the expense of investors. Firms are prompting investors to either rely on proprietary products with higher fees and commissions or to trade more frequently through subtle psychological messaging. “What started off as concern over gamification expanded into a larger catch-all category,” says Benson Cohen, a partner with the law firm of Sidley Austin in New York. “Technology is evolving quickly, but the SEC has to be realistic.”
The regulatory agency’s definition of PDA is two-fold. It must be analytical, technological, or computational. It must also predict or direct investment outcomes. As a result, anything from a complex black-box algorithm to a spreadsheet containing an algorithm would fall in scope. Even a website could be affected if investors were prompted to trade based on any information in articles, performance metrics, graphics, or other cues.
Soft-dollar commission programs and securities lending transactions could also be impacted. “Given the inherent conflict presented, a firm would be required to eliminate the use of soft-dollar arrangements, regardless of the fact that there is a statutory safe harbor allowing for such use,” write the LSTA and other trade groups in their letter to the SEC. “Firms use technology for all aspects of securities lending, which in some cases can present a conflict with a customer or client.”
A conflict of interest would exist even if a broker-dealer or investment adviser has “an interest” in the PDA or PDA-like technology. Such a definition far exceeds the SEC’s historical interpretation of conflict of interest as putting the firm’s interest ahead of its clients. The new litmus test will be impossible to pass as firms will likely have some self-interest from any application. “The SEC is making the presumption that fund managers and broker-dealers operate in an environment of complete altruism which is simply not the case,” says Richard Marshall, a partner in the law firm of Katten Muchin Rosenman in New York. He adds that the proposal reflects “bad rulemaking” and believes the SEC would have been better off issuing an interpretative release on specific types of technology and flexing its muscle through enforcement action.
However, it is uncertain whether a milder approach would be sufficient based on what the regulatory agency hopes to accomplish. The SEC has abandoned its stance of being technology neutral. “The SEC’s proposal would represent a sea change in how it protects investors when firms rely on technological advancements,” says Steve Ganis, a Boston-based partner with the law firm of Mintz. “What constitutes a conflict and what one must do to fix a conflict would change drastically just because of the technology used.”
The problem of addressing conflict of interest is compounded by the fact that the proposed regulation contradicts not only legal precedent, but also proposals that have yet to be adopted such as those involving market structure, best execution, and the definition of an exchange. In its communique to clients, Morgan Lewis cites two examples of how broker-dealers could accidentally face a conflict of interest that could not be resolved through disclosure. One is the example of a broker-dealer using advanced data analytics to decide between execution venues in a matter of milliseconds. The other is a broker-dealer using advanced analytics to reduce its risk exposure to some clients and its capital exposure by limiting some clients’ ability to trade “meme” stocks.
If the SEC’s definitions of covered technology and conflict of interest using PDA weren’t hard enough to swallow, its explanation of the affected interactions with investors is even more troublesome. The new rule is a sharp contrast to legal precedent. “The SEC’s Regulation BI requirements for broker-dealers and its fiduciary duty requirements for investment advisers focus on the recommendation of a security or provision of investment advice,” explains David Adams, a partner with the law firm of Mintz in Washington, D.C. “In the case of predictive data analytics, the rules would apply even if no recommendation or advice is offered.” All that is needed is for the investor to be involved in the interaction either directly or indirectly.
The term indirectly is so vague that it could be interpreted to include risk analytics, collateral management, and even clearing which are considered middle and back-office functions. Taken to its extreme, the SEC’s proposal is nothing short of ludicrous to some legal experts. “Would the SEC consider a trade confirmation printed on a green piece of paper to be inappropriate, because the color prompts positive money-making thoughts?.” questions Marshall from Katten Muchin Rosenman.
The SEC’s definition of investors will also be challenging to address. For broker-dealers only retail investors would be affected, but for investment advisers any new rule would apply to institutional clients. Although they are supposedly sophisticated enough to invest in complex strategies and products, disclosure might not be sufficient to protect their interests. Firms registered with the SEC as both broker-dealers and investment advisers would have a harder time complying with the SEC’s new requirement than those with only one legal status. They would have to determine whether the investor interaction was carried out by either their brokerage or investment adviser unit.
Although firms must neutralize or eliminate conflicts of interest only when those interests are ahead of their clients’, all applications must be reviewed and monitored on an ongoing basis. The number of applications affected could range from a handful to several hundred depending on the size of the firm. “Larger firms will have more resources to do the work and far more applications to monitor, while smaller firms might have fewer applications and fewer resources,” says James Dolan, chief compliance officer for Boston-based Kezar Trading, which operates the Luminex and LeveL dark pools. As a result, both large and small investment advisers and broker-dealers will feel the compliance pain, he tells FinOps Report.
Investment advisers and broker-dealers won’t be the only ones faced with dealing with the SEC’s proposal on PDA. As written, the proposal does not distinguish between proprietary technology and applications provided by external firms. Therefore, investment advisers and broker-dealers would have to understand the data inputs and methodologies, if not the source code, used by vendors. It is uncertain how much information vendors will be willing to disclose and whether the SEC would accept documentation on how their technology functions as sufficient proof of compliance. Although the SEC acknowledges that it might be difficult to achieve complete transparency for the inputs and methodologies used by third-party vendors, investment advisers and broker-dealers will still be held liable for not eliminating conflicts of interest.
“I’m worried that without narrowing the scope of the proposal and providing additional guidance on how to comply with the final rule, chief compliance officers will be left with too much to interpret,” says Genna Garver, a partner with the law firm of Troutman Pepper in New York.”The SEC has left the industry to do most of the heavy lifting in the comment process to ensure the final version of the rule is workable.” The amount of finetuning required to appease the industry may prompt the SEC to issue altered proposal open for additional comment prior to adoption.
Given the expansiveness of the SEC’s proposal, all legal experts and others can think is that the regulatory agency didn’t do its homework. “Based on the number of requests for comments about specific details in the proposal and the SEC’s admission that it may be difficult or impossible to comply with the rule as unaltered, the SEC’s proposed rule is more of a work-in-progress rather than a complete and workable rule,” says Garver. “The SEC has left the industry to do most of the heavy lifting in the comment process to ensure the final version of the rule is workable.” The amount of finetuning required to appease the industry may prompt the SEC to issue a changed proposal open for additional comment prior to adoption.
Daniel Viola, a partner with the law firm of Seward & Kissel in New York, recommends that investment advisers and broker-dealers start preparing themselves for a worst-case scenario. It will take a village to satisfy the SEC. “Firms need to create conflict of interest committees, if they haven’t done so already,” he tells FinOps Report. “Compliance managers can’t handle the potential new requirements on their own and will require help from IT directors, portfolio managers, risk managers and marketing directors.”
Investment advisers and broker-dealers already face a plethora of proposed new regulations to address, so one more on predictive data analytics will only increase their anxiety and costs for no good reason. “The SEC’s proposing release does not make a compelling policy case for adopting [the PDA rules],” says Morgan Lewis in its communique to clients. “The proposal relies significantly on academic papers, but provides few real-world examples of investors being harmed by the types of technology that would be regulated by these rules.”