SEC Proposes New Conflict of Interest Regime for Predictive Technology

A wide range of technology would be swept up by the proposal, which forbids conflict disclosure as an alternative to elimination related to the covered technologies.



The Securities and Exchange Commission proposed a new rule last week requiring advisers and broker/dealers to eliminate or neutralize conflicts of interest that arise from their use of predictive analytics, artificial intelligence or other “covered technology.”

Specifically, advisers and broker/dealers must “eliminate or neutralize the effect of conflicts of interest associated with the firm’s use of covered technologies in investor interactions that place the firm’s or its associated person’s interest ahead of investors’ interests.”

“Covered technology,” according to an SEC factsheet, “includes a firm’s use of analytical, technological, or computational functions, algorithms, models, correlation matrices, or similar methods or processes that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes of an investor.”

Blair Burnett, an attorney with the SEC’s division of investment management, said at a July 26 open hearing that the proposal has three components. The proposal would require that a firm eliminate or neutralize the effect of a conflict of interest related to covered technologies. It would require written policies and procedures that describe the use of covered technologies and the conflicts associated with their use; the processes used to eliminate those conflicts; and an annual review of those procedures. Lastly, firms must keep appropriate records documenting their compliance with the rule.

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Two elements of the proposal have been identified by the dissenting commissioners and other experts as likely to be controversial in the financial industry: the inability to simply disclose conflicts of interest and the breadth of the definition of covered technology.

Disclosure vs. Elimination

Ethan Corey, a senior counsel with Eversheds Sutherland, says requiring advisers to eliminate conflicts without the option to disclose them “is pretty much unprecedented.” He explains that securities laws “do not preclude advisers from having substantial conflicts of interest,” but advisers do have the responsibility to disclose and mitigate those conflicts and obtain informed consent from clients.

Sanjay Lamba, an associate general counsel at the Investment Adviser Association, notes that advisers have fiduciary duties to their clients to disclose and mitigate conflicts as explained in a Commission Interpretation issued in 2019. “This proposal seems to departing from that interpretation regarding disclosure by not permitting it as an alternative to elimination,” Lamba said.

Corey says the SEC believes that conflicts created by artificial intelligence and predictive analytics, which are the primary but not sole target of the proposal, are relatively opaque, complicated and quick to evolve, such that disclosure is not a useful tool in addressing the conflicts generated by them.

Matt Rogers, an attorney with K&L Gates, adds that the SEC sees conflicts related to artificial intelligence as uniquely unfit for disclosure. The technology influences decisions in real time, and the disclosure might be too complex or evolving to be useful to investors. As a result, he says, this is “something the industry is going to push back on pretty hard.”

Adam Kanter, a partner in Mayer Brown, notes that the issue is more relevant for retail investors than  for institutional investors, because many robo-adviser services or algorithmic recommendations are geared toward smaller and less sophisticated investors. Retail investors “need more hand holding,” and the SEC likely has this on their mind as well. Kanter acknowledged that this change “would be fairly unique” by not permitting disclosure.

“Covered Technology” Definition

Despite AI being the main target of the proposal and a topic of interest for SEC Chairman Gary Gensler for months, this definition is “extremely broad,” according to Corey. Commissioner Hester Peirce remarked at the hearing that the SEC is effectively “banning technologies we don’t like.”

William Birdthistle, the director of the division of investment management at the SEC and a proponent of the rule, responded to Peirce and said he wants the proposed rule to be limited to technology that forecasts and directs investing. He acknowledged that the definition’s breadth is a “concern” and invited stakeholders to provide specific recommended changes when commenting to the SEC about the proposal.

As for whether this definition and proposal together are likely to discourage the use of covered technologies, Corey says, “the short answer is: Yes.”

Lamba concurs and explains that it will take a lot of work just to determine if a firm is even using covered technology. This proposal “would really discourage firms from using” covered technology, the definition of which goes far beyond AI. 

At the hearing, Peirce suggested the definition could apply to some uses of a Microsoft Excel spreadsheet. Rogers agrees this is a plausible interpretation of the proposal: “A spreadsheet could become a covered technology” by inputting demographic data on a client and then populating a model portfolio for that client; that spreadsheet is a component in computing, modeling and optimizing.

“I don’t think anybody thinks that a spreadsheet is AI,” says Rogers, “but based on how the rule is proposed, it would be captured.” He adds: “Without concrete examples, industry is really going to have a rough time to eliminate or mitigate a conflict if disclosure isn’t enough.”

The comment period for the proposal will remain open for 60 days following its entry in the Federal Register.

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Unicorns Hobbled Amid VC Pullbacks

Non-public companies valued at $1 billion and up haven’t sprung back with the stock market.




In mythology, unicorns have magical powers, from healing sickness to turning water potable.

In finance, their enchantment is fading, owing to over-valuation that lately has crashed. Unlike the flying, one-horned horses of fable, the financial unicorns—private startups worth $1 billion or more—have run up against forces pulling them back to earth.

On paper, venture capital-backed unicorns, many of them tech-tilted companies, are valued at $5 trillion. But their recent problems have sliced that in half, by the estimate of Coatue Management, a technology-oriented investment firm with both private and public holdings. There are “too many unicorns requiring too much capital,” a Coatue research presentation stated.

As initial public offerings and acquisitions have dried up, so has the ability of unicorns to furnish their VC backers with lucrative exits. Or any exits, for that matter: As these unicorns cannot go public or be bought by others, they have a hard time raising new money from now-dubious investors, by Coatue’s assessment.

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One problem: The field has become too crowded. A decade ago, when Aileen Lee of Cowboy Ventures coined the term, only 44 unicorns existed. By this year, that has swelled to 1,350, the firm’s report declared.

By Coatue’s measure, the unicorns’ valuation reductions are stark, cascading from their 2021 peaks. Consider three online companies that Coatue has re-valued: Grocery deliverer Instacart is down 69%, online payment processor Stripe is off 47% and Chinese fashion retailer Shein has fallen 34%. Yet, by the values those companies have announced, apparently all three still are unicorns (Instacart, for instance, places its worth at $10 billion).

Part of Coatue’s valuation method is to compare unicorns with similar young companies that have gone public in the last few years. Despite an overall market recovery in 2023 after a calamitous 2022, these new-ish publicly traded outfits still are far down from their maximum levels. Take DoorDash, a competitor to Instacart: It went public in December 2020 and peaked in November 2021.As of last Friday, it was off 63.5% from that high point.  

The lack of exits and the reluctance of investors to plug more capital into the unicorns stem from such factors as the administration of President Joe Biden’s push for antitrust enforcement against large tech companies and a credit contraction after Silicon Valley Bank’s collapse.

An S&P Global Market Intelligence research note concluded that the stretch from January to March was “the worst quarter for venture capital and early stage investing in [five] years, with the startup industry struggling to raise funds and stay afloat.” Thus, VC “funding in startups has seen a significant decline, with funding cut in half across North America.”

While in general, technology stocks have recovered from a 2022 dive, the same cannot be said for many fledgling companies. One big reason: Venture investors appear to have gone too far, and many are tapped out. The VC industry has “become bloated to unsustainable levels during the later years of the boom cycle,” a PitchBook analysis found. In 2013, there were 850 active VC firms, a number that by 2023 had ballooned to more than 2,500.

Certainly, some unicorns remain in great shape. Few doubt that artificial intelligence lab OpenAI (said to be valued at $40 billion, and the recipient of a big investment from Microsoft) and Elon Musk’s rocket launcher, SpaceX ($150 billion), have held up valuation-wise and could do well with a public offering.

But for the balance of the class, a dose of magic would sure come in handy these days.

 

Related Stories:

Private Market Technology Investments Are Here to Stay

GIC Leads $500 Million Funding into Consumer Credit Unicorn Affirm

Venture Capital Is Booming, But for How Much Longer?

 

 

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