The new SEC rules that will impact advisers that utilize the Internet

How is the SEC’s modernization attempt going to affect investment advisers and broker-dealers?

On July 26, 2023, the SEC proposed two new rules [1]. The first rule is designed to require investment advisers and broker-dealers (each, a Firm, together, Firms) to address conflicts of interest where the Firms may be placing the Firms’ interests ahead of the investors’ interests as they relate to the uses of a Covered Technology (as defined below), including predictive data analytics (“PDA”) or similar technologies (the Conflict of Interest Rules).

The second rule was adopted March 27, 2024[2] and updates SEC Rule 203A-2(E) (the “Internet Adviser Exemption”) to require that investment advisory services be offered exclusively through an operational interactive website (as defined below) in order for an investment adviser to be permitted to register as an investment adviser with the SEC (as opposed to registration at the state level) (the “Amendment to the Internet Adviser Exemption”). Only one (1) commentor disagreed with the finalization of the rule. Only eight (8) comments were received in total with most supporting the new rule.

Together, these new rules and the SEC’s focus on modernization of its rules around technology will lead to new challenges and opportunities for Firms and their clients that are leveraging the internet and technology in their business. Understanding the rules now may produce competitive advantages over others who are not well-versed on the new rules. Firms should be considering how to implement process updates to comply with the new rules. Doing this now can reduce regulatory costs and better manage regulatory risks.

Who would the new rules apply to?

The Conflict of Interest Rules apply when Firms use Covered Technologies (as defined below) in investor interactions. They would apply to all broker-dealers and to all investment advisers registered, or required to be registered, with the SEC.[3]

The Internet Adviser Exemption provides an exemption to the prohibition against SEC registration for investment advisers that provide advisory services through the Internet. The exemption allows them to register with the SEC instead of going through a state or multi-state registration process. The Amendment to the Internet Adviser Exemption narrowed the exemption so that less investment advisers can rely on it.

What would change because of the Amendment to the Internet Adviser Exemption?

Before the adoption of the Amendment to the Internet Adviser Exemption, the Internet Adviser Exemption requires that an investment adviser (i) provide investment advice to all of its clients exclusively through an interactive website in order to qualify for an exemption from registration under the Investment Advisers Act of 1940, except that the investment adviser may provide investment advice to fewer than fifteen (15) clients through other means during any twelve (12) month periods (with a record demonstrating compliance.[4] and (ii) not control, not be controlled by, and not be under common control with, another investment adviser registered with the SEC solely in reliance on an adviser registered under the Internet Adviser Exemption

The SEC eliminated the de minimis exception in the Internet Adviser Exemption that would allow the investment advisers to have fewer than fifteen (15) non-internet clients in a twelve (12) month period. Therefore, the internet investment advisers would have to provide services to all its clients exclusively through the operational interactive website. The de minimis exception was included in the Internet Adviser Exemption so that it still applies even if the internet investment adviser is providing advice to a small number of clients not through an interactive website. However, the SEC now believes that the de minimis exception is no longer needed given the availability and prevalence of other exemptions.

In addition, the Amendment to the Internet Adviser Exemption requires investment advisers relying on the Internet Adviser Exemption to provide services to all of their clients exclusively through an operational interactive website (defined below) instead of just an interactive website at all times. An “operational interactive website” means “a website, mobile application, or similar digital platform through which the investment adviser provides digital investment advisory services[5] on an ongoing basis to more than one client (except during temporary technological outages of a de minimis duration).”[6]

The SEC believes that internet investment advisers who rely on the Internet Adviser Exemption can set up a fully operational interactive website within one hundred and twenty (120) days. The SEC included mobile applications in the rule so that the advisers would have broader flexibility in their user interface design. The SEC stated that if the investment adviser is initially relying on rule 203A-2(c)[7] as a basis for registration (i.e., the "120-day rule"), the interactive website would need to be operational within one hundred and twenty (120) days of the adviser’s registration. For example, an adviser could register with the SEC in anticipation of reliance on the Internet Adviser Exemption by using the one hundred and twenty (120) day rule, have no clients with no website, and within one hundred and twenty (120) days create an operational interactive website and obtain more than one client, then file an amendment to its Form ADV indicating that it has become eligible for the Internet Adviser Exemption.

Lastly, the adopted rules amended Form ADV to require the advisers who rely on the Internet Adviser Exemption to represent on Schedule D of their Form ADV that they have an operational interactive website.

One key consideration that Internet Investment Advisers must think about now is whether registering with the SEC is the best decision, especially in the context of the new Conflict of Interest Rules that proposes to heavily regulate Firms’ use of technologies.

What are the Conflict of Interest Rules?

The SEC proposes to require Firms to take the following affirmative steps to identify, determine, and eliminate, or neutralize the effect of these conflicts of interest.

Step 1: Firms will need to evaluate their use or reasonably foreseeable potential use of a Covered Technology (as defined below) in investor interactions and identify if there appears to be a conflict of interest.

Step 2: Firms will need to determine whether the identified conflict of interest in the investor interaction places the Firms’, including an associated person’s, interest ahead of the investors’ interests.

Step 3: Firms will need to either eliminate or neutralize[8] any conflict of interest where the Firms’ interests are put ahead of the investors’ interest, as determined in Step 2 (Step 1 through Step 3, the Conflict Resolution Steps).

What is a Covered Technology under the Conflict of Interest Rules?

In the Conflict of Interest Rules, the SEC focused on the term “covered technology.” The SEC defines the term very broadly 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” (each a "Covered Technology").[9]

The intention is to include all PDA-like technologies from artificial intelligence to neural networks and large language models, as well as technologies that use historical or real-time data, and others not mentioned in this article.[10] The definition of a Covered Technology is drafted to include a wide range of methods and tools. One of the limitations noted in the rules is that the Covered Technology would be limited to “those technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes.”[11] The purpose of this broad scope is to not only cover the technologies in use today, but also those that are developed through innovation.

However, a Covered Technology does not include the technologies that are purely informative or that predict whether an investor’s credit card application would be approved or not based on the information the Firms know about. The rules are not intended to cover technologies that do not affect investment-related behaviors or outcomes.[12]

What is an “investor interaction” under the Conflict of Interest Rules?

For brokers or dealers, an investor is “a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family[,] or household purposes. The definition is designed to capture both prospective and current retail investors.”[13]

For investment advisers, an investor is “a client or prospective client, and any current or prospective investor in a pooled investment vehicle advised by the investment adviser.”[14] The purpose of such separate definitions is to broaden the scope of the applicable rules.

The new rules define investor interaction as “engaging or communicating with an investor, including by exercising discretion with respect to an investor’s account; providing information to an investor; or soliciting an investor.”[15] The SEC purposefully intends the definitions to be broad so that it covers a wide variety of methods that use current and future technologies when the Firms interact with investors.

The SEC noted that the rules only apply when the Firms use a Covered Technology in interactions with investors. For example, Firms use of a Covered Technology to “analyze historical data and current market data to identify trends and make predictions related to the firm’s intra-day liquidity needs, peak liquidity demands, and working capital requirements” is not considered an investor interaction.[16]

Investors’ interactions through the use of a Covered Technology can be direct or indirect. A website or a digital platform showing a prompt to investors that leads to investment-related behaviors or a broker who uses a Covered Technology to generate recommendations of investment products emails the results to investors are all considered investor interactions under the new rules.[17]

In addition, Firms need to be careful with their use of research pages, email subscription services and alerts that notify the investors if there is news affecting the investors’ portfolio or watchlist. These are all included in the new rules as the SEC argues that these “are designed to, or have the effect of, guiding or directing investors to take an investment-related action.”[18]

Lastly, under the rules, investor interactions do not include those interactions that are “solely for purposes of meeting legal or regulatory obligations,” including anti-money laundering purposes.[19] The SEC emphasized on the word “solely” and noted that the interactions will be considered investor interactions for the purpose of the rules if they involve actions that would lead or prompt the investors to invest or trade.[20]

How should investment advisers complete the Conflict Resolution Steps?

The rules did not discuss any standard method or solution which Firms can use to evaluate a Covered Technology in use. Each Firm may adopt an approach uniquely suitable for what it needs. If a Firm uses simpler technologies, their approach can be simple. As the complexity of technologies grows, the Firms must take additional steps to make a more thorough evaluation.

Whether the technologies are internally developed or licensed from third parties, the Firms must evaluate the potential of conflicts of interest. As the SEC noted, Firms should review the source code or built-in “explainability” features that provide the reasoning behind the recommendations or conclusions.[21] When Firms are licensing from third parties, they will need to review the documentation and understand how the technology might create conflicts of interest. “Black box algorithms”[22] cannot be used unless the Firms have taken all the Conflict Resolution Steps.

As part of Step 1, the SEC noted that Firms need to test a Covered Technology before implementation or any material modification and they need to test a Covered Technology periodically after that.[23] The rules do not specify the frequency of testing but a new Covered Technology or material modification to the existing ones must be tested before implementation. Firms need to create their own policy and determine how frequent they should test or retest a Covered Technology based on the nature and the complexity of the technology.

In investor interactions, if the Firm’s use of a Covered Technology considers any Firm-favorable information, the Firm will need to determine whether such use would place the interests of the Firm or its associated persons ahead of the investors’ interests. The SEC argues that the broad definition of conflicts of interest is needed to cover the many possibilities. For example, it would include the situation where there is only one factor in an algorithm that might tip the scale of the preference between the Firm’s interest and investor’s interest.

Firms can also create conflicts of interest when their use of Covered Technology in investor interactions takes into account the Firm’s profits or revenues.[24] In such cases, there will be a conflict of interest under the rules. For example, when a Firm ranks the options presented to investors by considering the revenue the Firm would receive.

Step 2: Firms will need to determine whether the identified conflict of interest in the investor interaction places the Firms’, including an associated person’s, interest ahead of the investors’ interests.

Next, Firms will need to determine if the conflict of interest would put the Firm’s interest before the investors’ interest by analyzing the following factors: “covered technology, its anticipated use, the conflicts of interest involved, the methodologies used and outcomes generated, and the interests of the investor.”[25] For example, if a performance-based fee is considered by the Firm’s financial model and a result would not be listed because of an insufficient performance fee for the Firm, the Firm is putting its own interest ahead of the investors’ if the result would be otherwise acceptable to the investors.

Through analyzing the factors, Firms may be able to determine that they are not prioritizing their interests if the outcomes would be equal or favorable to the investors.

Step 3: Firms will need to either eliminate or neutralize any conflict of interest where the Firms’ interests are put ahead of the investors’ interest, as determined in Step 2.

Firms that place their interests ahead of investors’ interests must take, eliminate, or neutralize the effects of those actions caused. Whether a Firm has successfully eliminated or neutralized the effect of a conflict of interest depends on whether the interaction no longer places the interests of the Firm ahead of the interests of investors.[26] A Firm could eliminate the effects by stopping use of a Covered Technology entirely or neutralize the effects by preventing the Covered Technology from using biased or favorable information.

In addition, a Firm must take actions promptly. Each case will vary based on the complexity of the elimination or neutralization process. The SEC noted that if a Firm needs a substantial amount of time to eliminate or neutralize the effects of the conflicts of interest, the Firm needs to take into account whether continuing to use the technology would violate its fiduciary duty.

Further, each Firm must eliminate or neutralize the effects of the actions it reasonably should have identified. The SEC noted that a Firm must use reasonable care to make a determination instead of assuming that its use of a Covered Technology does not place its own interest ahead of investors’ interests. Essentially, Firms must understand a Covered Technology that they are deploying or will be deploying.[27] The SEC’s rules would inadvertently put more burden on Firms to spend more resources to evaluate any potential Covered Technology they might use.

What governance requirements are there that Firms must follow related to the Conflict Resolution Steps?

Written descriptions of each of the three steps must be adopted and updated periodically. A written review of the policies and procedures must be provided at least annually.[28] All such records will need to be preserved for not less than six (6) years if the Firm is a broker-dealer and not less than five (5) years if the Firm is an investment adviser.

What should you do now to prepare?

First, understand if you may benefit from SEC registration or if your current SEC registration may be in jeopardy due to the Amendment to the Internet Adviser Exemption, and consider talking to your administrator or legal counsel about how to update your registration. The Amendment to the Internet Adviser Exemption will be effective ninety (90) days after the final rule is published in the Federal Register.

Second, consider the Conflict Resolution Steps now and be prepared to have to complete them formally in the near future. While this rule is still only a rule, we have seen the SEC move quickly to finalize new rules and implement effective dates shortly thereafter (e.g., ninety days (90)).

[1] Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers, Release No. 34-97990 (July 26, 2023) (https://www.sec.gov/files/rules/proposed/2023/34-97990.pdf) Exemption for Certain Investment Advisers Operating Through the Internet, Advisers Act Release No. 6354 (July 26, 2023) (https://www.sec.gov/files/rules/proposed/2023/ia-6354.pdf)