SEC’s Gensler Confirms AI is Regulatory Priority

Chairman Gary Gensler  said at a conference that he has directed the SEC to explore the regulatory implications of AI in financial advising, and also reiterated the importance of advisers vetting third-party services.

Securities and Exchange Commission Chairman Gary Gensler said that he has asked the SEC staff to make recommendations to the commission on the challenges of regulating artificial intelligence.

In brief remarks made to a conference on emerging trends in asset management on Friday, Gensler discussed the importance of regulations concerning AI, especially as it relates to fiduciary duties, and made yet another public confirmation that the SEC’s staff is actively working on regulatory recommendations in this area.

AI may prove to be “more transformative than the internet itself” Gensler said at the conference. He noted that AI can bring large benefits in terms of investment returns and access to markets, and specifically highlighted its potential role in sentiment analysis and advising.

As he has in other settings recently, Gensler also explained that the way AI software is programmed can create conflicts of interest if the AI tools are made to consider the interests of the adviser in addition to the client. To the extent that these are mutually exclusive, such programming would be a conflict and has implications for adviser fiduciary obligations. Here, on fiduciary status, is where Gensler’s focus is most concentrated, if his public remarks on AI are any indication.

Third Party Services

Gensler also briefly discussed outsourcing, custody, and cybersecurity under the umbrella of “third party services.”. He touched on the SEC’s outsourcing proposal, which would require advisers to do due diligence on their providers, identify and mitigate risks of outsourcing, and ensure an orderly termination of services at the end of their relationship, among other requirements. Gensler said that this proposal, as well as the cyber security proposals, are essential for an adviser to satisfy their fiduciary duties.

The chairman framed the new custody rule proposal, or the safeguarding rule, as belonging to this larger effort to extend adviser fiduciary duties to third parties by including their qualified custodians. This proposal, likely more than the others, have received significant pushback from industry.

Lance Dial, a partner and member of the asset management and investment funds practice at law firm K&L Gates, says that negative sentiment on this proposal is “carried by everyone in the industry.” It is unpopular for a variety of reasons, according to Dial, including its attempt to regulate custodians indirectly by requiring advisers to get assurances from their custodians. Dial explains that the contractual agreements it requires would limit the custodians that are available to advisers since they would have to negotiate with them separately, and they could lose business of clients using particular custodians.

The new custody rule would also extend these requirements to advisers engaged in discretionary trading. Though these advisers do not have custody of assets in the traditional sense, they could still unjustly take client assets through fees if they were trading excessively, a practice known as churning. Dial explains that this is more of a fiduciary problem than a custodial one, which the new proposal would not address.