Regulatory Roundup: SEC Probes AI in Investment Advisory and Unpacking the Corporate Transparency Act

In a strategic move that reflects the ever-evolving financial landscape, the SEC has launched a sweeping examination into the use and oversight of artificial intelligence (AI) tools used by investment advisers. This initiative, part of the SEC’s broader focus on the implications of AI within the financial industry, underscores the regulatory scrutiny surrounding the use of advanced technologies. This initiative is a testament to the SEC’s commitment to maintaining market integrity and safeguarding investor interests in an era of rapid technological change.

SEC Chair, Gary Gensler, has voiced concerns about the significant risks associated with the growing use of AI in the industry. The SEC is now examining how investment advisers implement AI, prompting discussions about possible conflicts of interest, inadvertent biases, and the need for adequate safeguards. Investment advisers are now at a pivotal juncture where they must align their AI strategies with regulatory standards and best practices. Arootah Advisor Michelle McGurk unpacks the latest SEC compliance initiatives and addresses the new rules aimed at short-selling transparency.

What You Need to Know: The SEC’s Areas of Concern

The SEC has launched a targeted information-gathering process known as a “sweep.” While the agency has not publicly disclosed specific targets in its recent inquiries, the focus includes obtaining insights into AI-related marketing documents, algorithmic models shaping portfolio management, engagements with third-party AI providers, and the nature of compliance training. The SEC’s inquiries span topics such as

1. The management of potential AI-linked conflicts of interest
2. Contingency plans for AI system failures
3. Reports on AI systems causing regulatory or legal issues
4. Examples of advertising referencing AI

In light of the accelerating adoption of AI across the financial industry, including major players such as BlackRock, Fidelity Investments, JPMorgan Chase, and Goldman Sachs, the SEC’s move reflects a proactive effort to understand the potential risks and challenges associated with these technologies. While these firms tout the benefits of AI in enhancing market access, efficiency, and returns, the SEC is keen on ensuring that such tools do not compromise investor interests or introduce conflicts that could result in financial harm.

In an authoritative stance reflecting the potential risks of AI consolidation, Gensler has highlighted the concerning trend where a select few tech giants dominate the supply of enterprise-grade AI models. This concentrated market dynamic implies that many financial institutions could rely on a singular AI provider’s model, which may result in repercussions that cascade across multiple institutions and increase systemic risks to the broader economy.

Best Practices for Firms Implementing AI

As investment advisers navigate the evolving landscape of AI regulation, adopting the best practices is critical for effective compliance and risk management. This includes

1. Implementing risk governance and model validation frameworks
2. Ensuring human oversight
3. Establishing robust safety protocols
4. Identifying and mitigating conflicts of interest
5. Adhering to privacy and data governance principles.

Transparency, bias mitigation, and accountability are paramount, especially as the SEC intensifies its focus on firms overstating their AI capabilities, a practice known as “AI washing.”

As firms navigate the SEC’s sweep of AI use, it’s imperative for advisers to ensure they maintain sufficient documentation proactively. This documentation should cover critical aspects of the firm’s risk management over AI, including an inventory detailing where and how AI-based tools are integrated into the firm’s operations. Firms must be able to provide insight into the policies and procedures governing AI use, both internally and with investors. The documentation should also highlight robust security controls in place to safeguard client data utilized by AI systems.

Additionally, firms should be able to furnish information on their AI software developers and oversight managers, ensuring transparency. Comprehensive details on the sources and providers of data utilized in AI tools and models are essential, demonstrating diligence in sourcing information.

Reports or results of validation and testing procedures performed on the firm’s AI-based tools should be made available, highlighting the commitment to rigorous testing standards. Internal reports documenting any incidents where AI use led to regulatory, ethical, or legal issues must also be disclosed. Business continuity plans addressing AI system failures or errors should be thoroughly documented, emphasizing the firm’s commitment to proactive risk management and preparedness.

Providing a list of governance committees with specific AI-related responsibilities and associated documentation is crucial for showcasing effective oversight. Although AI systems undoubtedly provide significant efficiency gains, they need to be closely monitored and scrutinized.

Disclosure of AI Use in Marketing Materials

In response to the SEC’s focus on AI use and recent exam focus on compliance with the Marketing Rule, advisers should reassess marketing materials referencing AI. The SEC emphasizes accuracy, requiring firms to prevent false facts, misleading content, and deception in advertisements. Firms must assess their policies, ensure they avert violations, disclose consistent marketing information related to AI on Form ADV, and maintain evidence of procedures.

SEC’s Proposed Rules on Predictive Data Analytics

The SEC’s sweep of AI use by advisers aligns with its broader regulatory agenda. In July 2023, the SEC proposed rules related to the use of predictive data analytics, including AI, by broker-dealers and investment advisers. The proposed rules aim to address conflicts of interest associated with the use of these technologies, emphasizing the need for firms to prioritize investors’ interests over their own. We are in the midst of a historic transformation from advancements in predictive data analytics and AI and the proposed rules are designed to ensure that firms using such technologies meet their obligations to eliminate or address conflicts of interest and prioritize investors’ interests.

Key Takeaways for Investment Advisers

As investment advisers increasingly adopt and assimilate AI due to its transformative potential, it is crucial to seamlessly integrate these technological advancements into a robust compliance framework that prioritizes the interests of investors. Proactive adoption of AI best practices, coupled with conflict-of-interest assessment and resolution processes, is vital for navigating the evolving regulatory landscape. This approach will ensure a smooth integration of AI technologies into investment processes and operations. Moving forward, the industry should expect ongoing regulatory scrutiny of AI practices, with a deeper focus on conflicts of interest and investor protection.

Corporate Transparency Act (CTA) Imposes New Beneficial Ownership Reporting Requirements

The Corporate Transparency Act (CTA), ushered in as part of the National Defense Authorization Act in January 2021, mandates detailed beneficial ownership reporting, known as the “BOI Rule” for certain U.S. and foreign business entities (“Reporting Companies”) operating in the United States. Overseen by the Financial Crimes Enforcement Network (FinCEN), the CTA targets increased transparency, combats money laundering, and aims to curb criminal activities linked to entities with opaque ownership structures that fall outside of existing federal or state oversight.

Entities newly formed or registered to conduct business in the United States between January 1, 2024, and January 1, 2025, must adhere to beneficial ownership reporting requirements. This involves submitting a report to FinCEN within 90 calendar days of registration or formation, if the entity is created or registered after January 1, 2025, the report must be filed within 30 calendar days. Existing entities are granted until January 1, 2025, to adhere to these regulations, and there are currently no extensions available for new or existing entities subject to these rules.

Additionally, any changes to the reporting company or its beneficial owners must be reported within 30 calendar days to ensure the information reported to FinCEN is accurate and up to date. Non-compliance with the CTA can result in both civil and criminal penalties, highlighting the importance of understanding and adhering to the new regulations.

Am I Affected?

The CTA covers a wide range of entity structures, such as corporations, limited liability companies, and limited partnerships, both domestic and foreign. While 23 exemption categories exist for many existing regulated companies, including private investment funds, public companies, registered investment advisers, and registered investment companies, the CTA requirements will more significantly impact holding companies, family limited liability companies, entities formed for acquisition purposes, such as special purpose vehicles, joint ventures or other strategic partnerships, and smaller operating businesses.

Reporting Beneficial Ownership

Entities classified as Reporting Companies under the CTA are obligated to identify and report each beneficial owner, along with any individual recognized as a company applicant in relation to that Reporting Company. A “Beneficial Owner” under the BOI Rule is defined as an individual who exercises “substantial control” over the company or those owning or controlling 25% or more of the ownership interests, with consideration that convertible interests, options, and other equity rights shall be treated as if they are exercised. Determining ownership requires consideration of both direct and indirect ownership, which complicates the process for some entities, including those with complex partnership waterfalls and other arrangements that impact the calculation of ownership interests. A “Company Applicant” can consist of two individuals: the company filer, who submits necessary documents to establish and register the entity, such as an attorney, and another individual from the entity who instructs the company filer.

Reporting Information

Reporting Companies are required to submit detailed information about the entity, including

1. Legal and trade names
2. Principal place of business
3. Jurisdiction of formation
4. Unique IRS taxpayer ID numbers

Required information to be disclosed on beneficial owners and company applicants includes

1. Full legal name
2. Date of birth
3. Address
4. Identification document number (such as a driver’s license, passport, etc.),
5. Copy of the accepted identification document.

The submitted information is intended to be confidential but may be accessible to authorized officials for specific purposes.

FinCEN is developing a secure online portal for BOI report submissions, which is set to launch on January 1, 2024, 90 days ahead of the initial reporting deadline for newly formed or registered entities. Reporting Companies should closely monitor FinCEN’s guidance for updates and instructions.

Key Takeaways for Investment Advisers

Investment advisers, especially those not registered with the SEC, might be required to submit BOI reports for their management companies, general partners, or affiliates. Smaller businesses and entities formed for specific purposes should carefully evaluate their obligations under the CTA.

If a “private fund adviser” is exempt from registration under Rule 203(m)-1 of the Investment Advisers Act of 1940 and isn’t registered with the SEC, it won’t qualify for the related exemption as a reporting company. However, if such an adviser is created through a domestic filing or registered to operate in the U.S., it falls under the CTA regulations and must adhere to BOI reporting requirements.

Notably, a private fund adviser that is exempt from SEC registration but registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a Commodity Pool Operator (“CPO”) or Commodity Trading Advisor under CFTC Regulation 4.7 is exempt from reporting under the CTA. However, CPOs exempt under CFTC Regulation 4.13 would generally not qualify for this exemption unless another applies.

An entity classified as a “venture capital fund adviser”, as defined under Rule 203(l)-1 under the Advisers Act, is considered exempt as a reporting company under the CTA regime as long as it files its Form ADV with the SEC which includes BOI of the venture capital fund adviser.

Regulated private investment funds and registered investment advisers typically qualify for an exemption as a reporting company under the CTA. However, these new rules might affect investments in unregulated private entities, necessitating more detailed information from major investors. Furthermore, a parent or upstream entity with stakes in a registered investment adviser or another exempt entity might not qualify for the exemption and could be obligated to report to FinCEN.

As the CTA redefines reporting standards for entities, understanding the specific requirements and implications is critical to adhere to the new regulations and avoid potential penalties, including fines and imprisonment. Investment managers and relevant entities must stay updated, consult with legal experts, and adjust their strategies to navigate these changes effectively and ensure a seamless transition to the updated reporting framework.

Hedge Fund Associations Challenge SEC’s Short-Selling Regulations: What Lies Ahead?

In a firm stance reflecting the hedge fund industry’s concern with regulatory overreach, three major hedge fund associations have filed a lawsuit against the U.S. Securities and Exchange Commission (SEC), targeting the agency’s new rules aimed at short-selling transparency. The lawsuit, which was brought by the Managed Funds Association (MFA), the Alternative Investment Management Association (AIMA), and the National Association of Private Fund Manages (NAPFM), was filed in the 5th U.S. Circuit Court of Appeals and represents the industry’s latest push back against what it views as excessive regulatory intervention.

A Clash Over Transparency

The SEC’s newly adopted short sale disclosure rule (13F-2), which we highlighted in our October Regulatory Roundup, is designed to enhance transparency surrounding short-selling and securities lending—activities frequently intertwined in the financial markets. While the regulations mandate the reporting of short positions and individual securities loans, they also aim to safeguard investors’ positions by allowing the aggregation of certain transaction reports.

However, hedge fund associations argue that the SEC’s approach reflects inconsistencies that could jeopardize investors and breach provisions of the Administrative Procedure Act. Bryan Corbett, President and CEO of the MFA, criticized the SEC’s contrasting treatment of interconnected rules, highlighting the importance of a unified regulatory approach.

The industry’s resistance to increased transparency is rooted in concerns about the potential exposure of confidential investment strategies. Industry groups warn that the rules, while anonymized, could inadvertently reveal sensitive trading strategies, exposing funds to front-running and other manipulative tactics. This legal challenge is not an isolated incident but part of a broader industry backlash against the SEC’s recent regulatory initiatives. The industry’s concerted efforts to contest the rules reflect a growing apprehension within the industry about regulatory constraints and their impact on market dynamics.

In response to the lawsuit, the SEC reaffirmed its stance and ongoing commitment to vigorously defend the contested rules. The agency’s push for greater transparency in short-selling activities is underpinned by a desire to monitor market dynamics, especially during periods of heightened volatility.

Gensler has been a vocal proponent of increased oversight in this area, particularly following the GameStop trading frenzy in 2021. The SEC’s robust regulatory agenda, characterized by a series of new rules and initiatives, has drawn both praise and criticism, underscoring the complex interplay between regulatory objectives and industry interests.

Key Considerations for Investment Managers

To effectively navigate the challenges and uncertainty of an increasingly complex regulatory landscape, investment managers need to be agile and prepare to quickly adjust to new regulations and reporting requirements. While the outcome of this lawsuit remains uncertain, investment managers can play a role in influencing future regulations by engaging in meaningful discussions with regulatory bodies, promoting solutions that enhance market efficiency, and safeguarding investor interests. As regulatory oversight intensifies, investment managers should review their risk management strategies, aiming to achieve a balance between transparency and safeguarding their unique investment approaches.

The hedge fund associations’ recent lawsuit against the SEC’s short-selling rules marks a significant development in regulatory pushback from the industry. This legal action follows another lawsuit filed on September 1st, 2023, by hedge fund industry groups against the SEC’s newly enacted Private Fund Adviser rule. The pending outcome of this lawsuit highlights the overarching friction between regulatory goals and industry interests.

The Bottom Line

Investment managers must adopt a proactive approach, navigating the evolving regulatory landscape with vigilance and strategic foresight. The industry’s pushback against the SEC’s regulatory initiatives highlights the need for collaborative efforts to develop balanced and effective regulatory frameworks that promote market integrity and innovation. The SEC’s examination into the use of AI by investment advisers marks a significant step in regulatory oversight within the financial industry. As AI technologies become more integrated into financial services, the SEC is proactively seeking to understand the associated risks and ensure that investor interests are protected. Investment advisers must now navigate this new landscape with diligence, ensuring compliance with regulatory expectations and adopting best practices for AI implementation.

Need help getting started? Our team of experts can help ensure you are compliant. Take the first step and find out how Arootah’s Hedge Fund Advisory can support you.

References:

https://www.sec.gov/news/speech/gensler-remarks-fsoc-121423
https://www.ft.com/content/8227636f-e819-443a-aeba-c8237f0ec1ac
https://www.fincen.gov/boi
https://www.fincen.gov/boi/small-entity-compliance-guide
https://www.govinfo.gov/content/pkg/FR-2022-09-30/pdf/2022-21020.pdf
https://www.managedfunds.org/press-releases/napfm-mfa-and-aima-challenge-sec-securities-lending-and-short-position-reporting-rules/
https://www.managedfunds.org/wp-content/uploads/2023/12/Petition-for-Review.pdf