On The Docket – Conflicts of Interest, AI Washing, and Off-Channel Communications

Posted on Chris Stanley

Welcome to the May 10, 2024 edition of On The Docket, which includes the following content:

  1. Always. Disclose. Conflicts. Of. Interest.
  2. SEC’s First “AI Washing” Enforcement Action Has More Beneath the Surface
  3. SEC “Off-Channel Communications” Enforcement Action Poses More Questions Than Answers

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Happy reading.

– Chris

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Always. Disclose. Conflicts. Of. Interest.

Below is a screenshot/excerpt from an SEC complaint that ultimately resulted in an almost $100 million judgment against an RIA.

At issue were undisclosed financial incentives to recommend certain investments.

When in doubt, spell it out.

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SEC’s First “AI Washing” Enforcement Action Has More Beneath the Surface

While the headline of the SEC’s recent enforcement action press release touts charges against two RIAs for “Making False and Misleading Statements About Their Use of Artificial Intelligence,” there’s a bit more baked into the orders than initially meets the eye (and that have nothing to do with AI).

Both cases essentially centered on “false and misleading statements” in advertising material – a violation of the SEC’s Marketing Rule. The fact that such statements involved the purported use of AI supplies a press-release-worthy headline and jumps on the ‘AI is everywhere’ bandwagon, but this is ultimately a Marketing Rule issue.

A few summary takeaways:

  • One RIA respondent claimed on its public website that it offered tax-loss harvesting services, but in fact the RIA did not offer any tax-loss harvesting services.

    Takeaway: Don’t make false claims in advertising material (related to AI or otherwise). The SEC will ask you to “show your work” and “prove it” in the course of exams.

  • The same RIA respondent’s public website featured hypothetical performance without any disclosure of its hypothetical nature. Bear in mind that the Marketing Rule significantly limits an RIA’s ability to publicly disseminate hypothetical performance, even with appropriate disclosure.

    Takeaway: Hypothetical performance may only be disseminated to a particular intended audience and an RIA must prove that such performance is “relevant to the likely financial situation and investment objectives of the intended audience” (which is effectively impossible in a public dissemination).

  • The same RIA respondent disseminated client testimonials without describing material conflicts of interest on the part of those giving the testimonials. One client that provided a testimonial had business relationships with the RIA’s CEO, another was previously retained by the RIA as an independent contractor, and yet another was a close family member of the RIA’s CEO.

    Takeaway: The foregoing conflicts are all examples of what needs to be disclosed in connection with a client testimonial.

  • The same RIA respondent unilaterally made changes to its advisory agreement and sent clients a link to the updated advisory agreement, but “did not identify what changes had been made, nor did it provide any mechanism for clients to provide or withhold informed consent to the change prior to it becoming effective.”

    Takeaway: While advisory agreements can generally be revised upon passive client consent (at least for SEC-registered advisers), clients must still be afforded a mechanism to withhold consent reasonably in advance of the amendment’s effectiveness.

  • The same RIA respondent’s advisory agreement contained a hedge clause that purported to relieve the RIA from liability for “any claim or demand” regardless of the theory of liability, and purported to cause the client to broadly indemnify and hold the RIA harmless from any third-party claim or demand.

    Takeaway: The SEC still continues to take a strong stance against what it believes to be overly-aggressive liability limiting clauses. Consider reviewing your current advisory agreements for any liability limitation language that goes too far.


SEC “Off-Channel Communications” Enforcement Action Poses More Questions Than Answers

The SEC has pursued “off-channel communications” enforcement actions for several years now, but all have focused on standalone broker-dealers or dually-registered broker-dealers / investment advisers.

Earlier this month, it instituted its first administrative proceeding against a standalone investment adviser. The settled order relates to communications both among the adviser’s personnel as well as communications with the adviser’s clients that were not retained in accordance with Rule 204-2 under the Advisers Act (the “Recordkeeping Rule”) and specifically subpart (a)(7) thereunder. Such communications occurred through “personal texting platforms” on “personal devices,” some of which automatically deleted such communications after 30 days.

Technically, the Recordkeeping Rule that advisers are subject to limits communication preservation requirements, in relevant part, to:

  1. Any recommendation made or proposed to be made and any advice given or proposed to be given;
  2. Any receipt, disbursement or delivery of funds or securities;
  3. The placing or execution of any order to purchase or sell any security;
  4. Predecessor performance; and
  5. Private fund preferential treatment notices.

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What’s a bit frustrating about this enforcement action in particular is that the order alludes to off-channel communications “about the adviser’s business” as being problematic without going into further detail. The Recordkeeping Rule technically does not extend to ALL communications “about the adviser’s business,” but only those communications related to the enumerated list excerpted from Rule 204-2(a)(7) above.

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Thus, the extent to which the SEC will read-in recordkeeping requirements beyond the technical requirements of the Recordkeeping Rule, or how broadly it will construe the literal text of the Recordkeeping Rule, appears unclear.

For a great summary of the uncertainty that exists within the SEC’s interpretation of the Recordkeeping Rule as created by its off-channel communication enforcement actions, check out this letter to the SEC by a variety of industry trade associations.