August 15, 2023 - In late July, the SEC proposed yet another rule aimed an investment advisers and broker-dealers, this one designed to prevent conflicts in the use of “predictive data analytics” and similar technologies in investor interactions (the “PDA Proposal”). The scope of the PDA Proposal is incredibly broad, would be subject to intense and prescriptive review and require significant compliance and recordkeeping. Moreover, once again the SEC veers from decades of accepted practice by requiring advisors and broker-dealers to completely eliminate any potential conflicts without permitting mitigation of those conflicts through disclosure and informed consent. The PDA Proposal also seems to conflict with existing rules, it appears to be operationally unfeasible and its economic analysis seems to significantly understate its costs. Following we review the technical requirements of the PDA Proposal and discuss the problems it would pose to advisers and broker-dealers (including those in the loan market). We end by identifying the next steps.
What does the PDA Proposal Say?
A recent comprehensive memo from Mayer Brown lays out the key provisions of the PDA Proposal. The PDA Proposal would apply to broker dealers, registered advisers and advisers who are required to be registered by the SEC. It would apply when a firm used a “covered technology” in an “investor interaction”. Mayer Brown explains that covered technology “would be defined broadly to mean 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. This definition would include widely used and bespoke PDA-like technology, future and existing technology, sophisticated technology as well as relatively simple technology, and technology that is developed or maintained at a firm or licensed from third parties.” As Commissioner Peirce describes in her scathing dissent statement, “spreadsheets, commonly used software, math formulas, statistical tools, and AI trained on all manner of data sets could fall within the ambit of this rulemaking.” An Investor Interaction would include “engaging or communicating with an investor (including by exercising discretion over an investor’s account), providing information to an investor, or soliciting an investor.” “This definition would capture a firm’s correspondence, dissemination, or conveyance of information to or solicitation of investors, in any form, including communications that take place in-person, on websites; via smartphones, computer applications, chatbots, email messages, and text messages; and other online or digital tools or platforms, such as trading apps.” Investor would include retail investors for broker-dealers and, for advisers, any prospective or current client or any prospective investor in a pooled investment vehicle advised by the investment adviser which would include CLOs. A Conflict of Interest would arise when a firm used a covered technology that takes into consideration an interest in the firm or its associated persons. As Sidley notes in its important recent memo, this definition “does not include the element of being contrary to the interest of customers that the SEC has previously required for something to be considered a conflict.” Sidley further notes that the PDA Proposal requires “that anytime a broker-dealer or investment adviser uses a “covered technology” in connection with engaging or communicating with an investor (including exercising investment discretion on behalf of an investor), the broker-dealer or investment adviser must evaluate that technology for conflicts of interest and eliminate or neutralize those conflicts of interest.” In a departure from decades of SEC practice, the PDA Proposal also eschews the use of disclosure and consent to mitigate a conflict and would apply even if the interaction with the investor does not rise to the level of a recommendation. Finally, as described in detail in the Mayer Brown memo, the PDA Proposal imposes very extensive requirements for developing costly policies and procedures on identifying conflicts and maintaining records on how they develop their policies on identifying conflicts and how they eliminate or neutralize such conflicts.
Major Takeaways. The PDA Proposal is astonishingly broad in its scope, imposes incredibly prescriptive requirements, abandons long-held SEC principles and seems to be wholly unnecessary given the SEC’s already existing rules that govern the duties of broker-dealers Reg BI) and investment advisers (Fiduciary Duty Interpretation). As Sidley notes, absent from the PDA Proposal is “any evidence of any actual abuse by broker-dealers or investment advisers involving PDAs or PDA-like technologies subject to regulation under the proposed rules.” Commissioner Peirce argues that contrary to the Commission’s statement that the proposal is technology neutral, it is in fact hostile to technology and would impose substantial burdens on the use of any technology to communicate with investors. Sidley also notes that “it will be especially challenging – particularly for smaller broker-dealers and investment advisers-to identify, evaluate, eliminate or neutralize conflicts for every technology they use in communications or investment management and to document and update this evaluation every year.”
What’s next? The PDA Proposal was recently published in the Federal Register and comments are due on October 10th, only 60 days from the date of publication. The LSTA has joined with several other trade associations in submitting a letter to the SEC explaining that the short comment period is unreasonable given the breadth and complexity of the PDA Proposal (and in the context of all the overlapping rule proposals proposed by the SEC) and requesting an additional 60 days to comment The LSTA continues to review the PDA Proposal and assess its negative implications for broker-dealers, CLO managers and other investment advisers involved in the broadly syndicated and private direct credit loan markets.
Please reach out to Elliot Ganz if you have any questions or comments.
