Advisors contend SEC crackdown on AI recommendations does not compute

A slew of financial planning groups and firms are warning that an SEC proposal to rein in advisors' use of AI and robo-advisor services threatens to undermine the industry's bedrock fiduciary principles. 

As part of nearly 60 letters submitted to the Securities and Exchange Commission by a deadline Tuesday, big-name firms like Raymond James, Morningstar and Betterment took aim at a 243-page proposed rule meant to ensure advisors aren't using new forms of technology to put their interests ahead of investors'. The SEC voted 3-2 on July 26 in favor of a rule that would make financial planners responsible for eliminating or mitigating any conflicts of interest that might arise from their use of technology like artificial intelligence, machine learning or sophisticated algorithms in their dealings with clients.

SEC officials explained then that they were concerned these advanced technologies might be violating firms' fiduciary duty to put their clients' interests first — sometimes without advisors even realizing that was happening. The proposed solution calls on financial planners to scrutinize all of their uses of technology for conflicts and to eliminate or "neutralize" any that they discover.

Industry groups and firms were given 60 days to comment. The letters they submitted by Tuesday hovered around two specific complaints: The proposal threatens to upend the long-standing norms established by advisors' fiduciary duty to clients. And it's so far-reaching that it would apply to technologies far simpler than AI and predictive analytics.

"These overly broad definitions will mean that advisers will be required to have policies and procedures in place to review, test and make determinations about conflicts of interest associated with even the use of a basic spreadsheet to prepare for an in-person client meeting," wrote Catherine Newell, the general counsel and executive vice president of Austin, Texas-based Dimensional Fund Advisors, in a letter to the SEC dated Oct. 10.

Many of the commenters noted that the SEC's fiduciary rule already calls on advisors to eliminate most conflicts of interest. The very few that can't be avoided can be dealt with through disclosure — that is, by informing clients of their existence.

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Aron Szapiro, the head of government affairs at the Chicago-based financial services firm Morningstar, said advisors, broker-dealers and wealth managers of other stripes expect payment for their services. Even something so straightforward as a flat monthly fee could be construed as a conflict under the SEC's proposal, he said, especially if it's paying for advice derived in any way from technology.

Does that then mean that those fees would have to be eliminated or "neutralized"?

"It is essential for the Commission to provide more comprehensive guidance on how firms can demonstrate that investors' interests are given priority while still permitting RIAs and BDs to charge fees for their services," Szapiro wrote in a letter dated Oct. 10. "The unintended consequence of this proposal, if adopted, would be to discourage many useful services to investors."

The Investment Adviser Association, which represents more than 600 independent advisors, contended that the SEC has not furnished evidence showing that existing regulations aren't up to the task of protecting investors from technology-related risks. 

"It is not clear why common business practices that have been disclosed and managed for decades suddenly would not be permissible merely because advisers are using covered technology, including technology that advisers have been using without an issue for decades," IAA general counsel Gail Bernstein and associate general counsel Sanjay Lamba wrote in a letter dated Oct. 10.

The SEC's proposal specifies that the new rule would apply to "analytical, technological or computational functions, algorithms, models, correlation matrices or similar methods or processes that optimize, predict, guide, forecast or direct investment-related behaviors or outcomes in an investor interaction." Jonathan Santelli, the executive vice president and general counsel at St. Petersburg, Florida-based Raymond James Financial, said the definition casts too wide a net.

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"The broad definition of a 'covered technology,' would apply to every aspect of Raymond James' business operations, even to mundane systems like electronic reminders for customers to consider rebalancing, Excel spreadsheets or greeting card generators meant to create goodwill," Santelli wrote in a letter dated Oct. 9.

Even some usually steadfast supporters of the SEC agreed some modification may be in order in this case. Joseph Brady, the executive director of the North American Securities Administrators Association, said that the proposal's language may need to be tightened to exclude "simple and mundane technologies."

"If the definition can be read to include things like 'spreadsheets' and 'calculators,' cautious registrants could waste time on technologies no one is worried about," Brady, whose organization represents state regulators throughout the U.S., wrote in a letter dated Oct. 10.

The SEC's proposal comes not only in response to the rise of robo-advisors but also popular online brokerages like Robinhood Markets. Defenders of these services often argue that they've helped democratize investing opportunities by lowering costs and barriers to entry.

Many regulators, though, worry that customers may be unaware that they are being given incentives to act in ways that perhaps aren't in their best interests. In August, Massachusetts Secretary of the Commonwealth William Galvin won a court case in his state against Robinhood after accusing the firm of carelessly promoting investment opportunities to its users without taking into consideration the needs of individual investors.

Galvin chimed in on the SEC's proposed rules for firms' use of AI and other advanced technology with a letter on Tuesday. In it, he argued that any technological service that encourages risky investments should be considered to be making a recommendation under federal rules. 

Recommendations, according to the SEC, are "calls to action" triggering not only advisors' fiduciary obligations to clients but also brokers' similar responsibilities under Regulation Best Interest. Reg BI, as the broker-dealer rule is known for short, also calls on firms to look out for clients' interests while placing a greater emphasis on the need to disclose unavoidable conflicts.

Betterment, which began offering robo-advising services in 2010, warned that new regulation could undo some of the progress made toward lowering investment barriers. In a letter signed by Seth Rosenbloom, the firm's general counsel, and two other legal representatives, Betterment argued that its reliance on automation is a big reason why it's able to keep its fees low.

Betterment's letter, dated Oct. 9, said it typically charges robo-advisor clients 0.25% of their assets under management with the firm.

"Without automation, it is not economical for advisers like Betterment to serve lower balance retail investors, and offerings that serve this population will simply cease to exist," Rosenbloom and his colleagues wrote. "Almost any use of technology would be covered by the Proposed Rule's burdensome and unworkable compliance requirements, effectively chilling all uses of technology, including beneficial uses."

The SEC will now take the comments under advisement while it decides whether or not to adopt the proposed rule.