The Relevant Statutes Do Not Authorize the Predictive Data Analytics Proposal

This is a comment on the predictive data analytics proposal from the Securities and Exchange Commission (Proposal). I am a scholar with the Mercatus Center at George Mason University. I taught securities regulation at the University of Virginia School of Law, served as deputy general counsel at the SEC, and practiced securities law. The Mercatus Center is dedicated to bridging the gap between academic ideas and real-world problems and advancing knowledge about the effects of regulation on society. This comment is not submitted on behalf of any other person or group.

Introduction

The SEC proposed to adopt rules to require broker-dealers (BDs) and investment advisers (IAs) to identify and to eliminate or neutralize conflicts of interest associated with their use of technologies, widely defined, such as predictive data analytics. As statutory authority for the Proposal, the SEC relied mainly on two subsections of statutes passed in the Dodd-Frank Act.

This comment analyzes those provisions the way an appellate court might consider them in a challenge to the SEC’s statutory authority to adopt final rules based on the Proposal and concludes that the SEC overstated the authority granted in the cited statutes. A court is likely to decide that the Proposal went beyond the limited aims Congress set for the SEC in the relevant statutory provisions.

Others have this same concern. A former attorney general and a former member of Congress said that the Proposal read “nonexistent authority in vague provisions to provide the SEC with the authority to regulate new and transformative technologies like [artificial intelligence], which Congress never intended to give the agency.”

Two commissioners also do not subscribe to the legal reasoning supporting the Proposal. They challenged it when the SEC employed the same subsections and a similar legal interpretation for new regulations on investment advisers to private funds. Commissioner Peirce said the SEC ignored the totality of the relevant congressional enactment and “its undeniable focus on standards of conduct as they apply to retail investors.” Commissioner Uyeda said the private fund rules relied “on a tortured reading” of the relevant statute and ignored the context of surrounding sections. The majority’s construction read out any limiting principle on the prohibition or restriction of adviser conflicts.

Federal Agency Interpretation of an Enabling Statute

When the SEC proposes and adopts a legislative rule, it needs a statutory source of authority. Under the Constitution, Congress, not a federal agency, sets the scope and terms of an agency’s rulemaking and enforcement powers. Actions by an agency inevitably demand that the agency read and construe the relevant statutes.

When an agency interprets a federal statute, it has a responsibility, just as a court does, to be a faithful agent of Congress and a steward of Congress’s choices. The goal of statutory interpretation is to enforce a decision made by the legislature, to do what the legislature wanted, without exceeding what the text permits. The principle of legislative supremacy guides statutory interpretation. Agencies and judges are expected to implement policies selected by Congress and not their own personal policy preferences or the policy goals of political leaders.

The Supreme Court’s normal method of determining an agency’s rulemaking power is to examine the text and context of the relevant statutes with a view to their place in the overall statutory scheme.

In determining whether Congress has specifically addressed the question at issue, a reviewing court should not confine itself to examining a particular statutory provision in isolation. The meaning—or ambiguity—of certain words or phrases may only become evident when placed in context. It is a fundamental canon of statutory construction that the words of a statute must be read in their context and with a view to their place in the overall statutory scheme. A court must therefore interpret the statute as a symmetrical and coherent regulatory scheme and fit, if possible, all parts into an harmonious whole. 

In the Proposal, the SEC did not follow this approach. Contrary to the Supreme Court’s method, the SEC relied on a specific statutory provision in isolation. That provision was section 15(l)(2) of the Securities Exchange Act together with the identical companion in section 211(h)(2) of the Investment Advisers Act. Those subparts should not be considered alone and out of context. They were part of a larger set of related congressional enactments in section 913 of the Dodd-Frank Act (Dodd-Frank 913), but the SEC did not assess the history, structure, and context of Dodd-Frank 913 to develop an informed understanding of Congress’s choices and boundaries.

A more comprehensive review was necessary. As discussed below, that review requires consideration of all of section 913 and the debate over many years about the standard of care BDs and IAs owe their retail customers when recommending a securities transaction. The review demonstrates that the Proposal disregarded critical limitations on the SEC’s power to adopt rules addressing possible conflicts of interest between customers and BDs or IAs.

Section 913 of the Dodd-Frank Act and Its History

Knowing the history of Dodd-Frank 913 helps to understand it. For years the SEC and investors have been discussing the standards of care for the relationship between customers and BDs as opposed to IAs. When providing investment advice about securities, BDs and IAs were subject to different standards under federal law. Investors were confused by the different standards, and for a long time that confusion was a concern for Congress and the SEC. As far back as 2004 and 2006, the SEC commissioned studies on investor understanding of the differences in the roles and obligations of BDs and IAs.

Then in 2010 Congress passed the Dodd-Frank Act. Section 913 required another study of the BD and IA standards of care “for providing personalized investment advice and recommendations about securities to retail customers” and also granted the SEC rulemaking authority to address the different standards of conduct for BDs and IAs. The structure and a summary of section 913 follow:

• Section 913(a) defined “retail customer” for purposes of section 913.
• Section 913(b) required the SEC to conduct a study of the standards of care for BDs and IAs “for providing personalized investment advice and recommendations about securities to retail customers.”
• Section 913(c) listed the considerations for the study.
• Section 913(d) required a report of the study.
• Section 913(e) required the SEC to seek public comment to prepare the report.
• Section 913(f) gave the SEC rulemaking power to address the standards of care for BDs and IAs “for providing personalized investment advice about securities to such retail customers” based on the study. This provision was put in a note to section 15 of the Exchange Act (15 U.S.C. § 78o).
• Section 913(g)(1) added two subsections to section 15 of the Exchange Act. Subsection (k), called “Standard of Conduct,” gave the SEC rulemaking power to apply the standard of conduct applicable to an IA under section 211 of the Advisers Act to a BD “when providing personalized investment advice about securities to a retail customer (and such other customers as the Commission may by rule provide).” Subsection (k) also specified how a standard should apply to three situations, one of which was when a BD sold only proprietary or other limited range of products. Sales of a limited range of products was not to be a violation of a BD’s standard of conduct, but the SEC could require the BD to give notice to a retail customer and obtain a consent or acknowledgement from the customer.
• Subsection (l), also added to section 15 of the Exchange Act, called “Other Matters,” said (1) the SEC shall “facilitate the provision of simple and clear disclosures” about the relationship between investors and BDs, “including any material conflicts of interest,” and (2) the SEC shall “examine and, where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for” BDs and IAs that the SEC deems contrary to the public interest and the protection of investors.
• Section 913(g)(2) added two subsections to section 211 of the Advisers Act. Subsection 211(g), called “Standard of Conduct,” gave the SEC power to adopt rules that required BDs and IAs, “when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide),” to act in the best interest of the customer. Any “material conflicts of interest shall be disclosed and may be consented to by the customer,” and the rules were to set a standard “no less stringent than the standard applicable to investment advisers under [two of the anti-fraud provisions in the Advisers Act] when providing personalized investment advice about securities.” Subsection 211(g) specified that commission or fee compensation should not be considered a violation of the standard and again defined “retail customer.”
• Subsection (h) of section 211, called “Other Matters,” was identical to Exchange Act section 15(l) added by Dodd-Frank section 913(g)(1).
• Section 913(h) added provisions to the Exchange Act and the Advisers Act to harmonize enforcement against violations of the standards of conduct for BDs and IAs.

A fair reading of the entirety of section 913 leaves no doubt that it addressed standards of care for BDs and IAs “for providing personalized investment advice and recommendations about securities to retail customers,” with an emphasis on disclosure and specifically disclosure of material conflicts of interest. Those words and concepts dominated section 913.

In 2011, the SEC did the further study required by Dodd-Frank 913 and continued to review the matter and hold investor roundtables. In 2019, the SEC invoked one of the sources of rulemaking authority in Dodd-Frank 913, primarily the authority in section 913(f), and adopted Regulation Best Interest to set standards of conduct for BDs. Regulation Best Interest complied with the limitations in Dodd-Frank 913. It applies when a BD makes “a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer” and requires full and fair disclosure of many items, including all “material facts relating to conflicts of interest that are associated with the recommendation.” The SEC also issued an interpretation discussing the standards of conduct for investment advisers.

The Proposal Did Not Comply With Key Limitations in Dodd-Frank 913

Now the SEC wants to use Dodd-Frank 913 to go much further to address BD and IA conflicts of interest. In doing so, the Proposal disregarded the essential limitations in Dodd-Frank 913 and proposed rules with concepts and definitions that the SEC admitted were extremely broad.

The Proposal covered “investor interactions,” which “have generally been viewed as outside the scope of ‘recommendations’ for broker-dealers,” and beyond the statutory concept of personalized investment advice about securities. A BD or IA would have an obligation to eliminate or neutralize a conflict of interest; disclosure would not be sufficient. The presence of any BD or IA interest to any degree would constitute a conflict of interest. No materiality qualification would apply. According to the Proposal, investors for an IA would include institutional clients, contrary to the definition of retail customers Congress specified in Dodd-Frank 913.

Other elements of the Proposal were expressly labeled as broad. For example, “covered technology” was “designed to capture a broad range of actions.”

Difficulties with the SEC's Interpretation of Statutory Authority 

The SEC singled out the words in subsections 15(l)(2) and 211(h)(2) as the basis for the Proposal without fitting those subsections into the history or context of Dodd-Frank 913. Sections 15(l) of the Exchange Act and 211(h) of the Advisers Act are identical. For simplicity, I will refer only to section 211(h). Subsection 211(h)(2) states the SEC shall “examine and, where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for” BDs and IAs that the SEC deems contrary to the public interest and the protection of investors.

That subsection does not specifically mention the same words of limitation used in section 211(g) or other parts of Dodd-Frank 913, and the SEC treated it as an unbounded, separate, and independent authority for rules prohibiting any and every IA conflict of interest (same for subsection 15(l)(2) and BD conflicts). The SEC chair articulated this broad view of subsection 211(h)(2) in his statement on new rules for advisers to private funds. He said: “Congress also gave the Commission specific new authorities under the Investment Advisers Act of 1940 to prohibit or restrict advisers’ sales practices, conflicts, and compensation schemes.” He specifically noted that Congress did not confine subsection 211(h)(2) “only to retail investors.”

This is not a fair or the better reading of subsection 211(h)(2). Section 211(h) follows the longer and more specific section 211(g) and is entitled “Other Matters.” That means other matters related to the rulemaking authorized in section 211(g) on the standard of conduct for IAs when giving advice to retail customers. It does not mean the universe of matters outside the rulemaking authorized in section 211(g). Section 211(h) therefore links directly to section 211(g) and its more detailed and limited rulemaking power.

Subsection 211(h)(1) confirms the connection. It provides additional guidance to the SEC when it acts under subsection (g). It instructs the SEC to prefer “simple and clear disclosures” to investors about their relationships with BDs and IAs and states that the preference for disclosures applies to “material conflicts of interest.” Subsection 211(h)(1) makes sense only as an integrated elaboration of the rulemaking power in the preceding section 211(g).

Subsection 211(h)(2) also follows from and is subservient to section 211(g). Subsection 211(h)(2) cannot be read outside of the context of section 211(g), subsection 211(h)(1), or the rest of Dodd-Frank 913. Because subsection 211(h)(1) must be seen as a congressional instruction supplementing the rulemaking source in section 211(g), so must subsection 211(h)(2).

One particular example depicts the inconsistency between the Proposal and a fair reading of sections 211(g) and (h). In subsection 211(g)(1), Congress stated categorically that the SEC “shall not ascribe a meaning to the term ‘customer’ that would include an investor in a private fund” that has an advisory contract with an adviser. That statutory command from Congress logically and structurally carries over to a rulemaking on conflicts under subsection 211(h)(2), yet the Proposal paid no attention to it. The proposed rules would apply to investment advisers to private funds and would define investor to include a client and “any current or prospective investor in a pooled investment vehicle advised by the investment adviser.”

An appropriate reading of subsection 211(h)(2) is that the SEC was first to address the major issues in section 211(g) and then “examine” other conflicts or sales or compensation practices. Subsection 211(h)(2) explicitly refers only to “certain” conflicts of interest or practices. That naturally means less than the matters in section 211(g). If the SEC identified “certain” exceptional situations that were harmful to investors and that were not already addressed and could not be addressed through disclosure, the SEC could prohibit or restrict conduct in those areas.

The overarching limitations in section 211(g) and Dodd-Frank 913 still apply to subsection 211(h)(2). The rulemaking power in subsection 211(h)(2) cannot properly be read to disregard the recurring themes in Dodd-Frank 913 on personalized investment advice, retail customers, disclosure, and materiality. The placement and terms of subsection 211(h)(2) stamp it as a narrow exception to the emphasis on disclosure in the rest of Dodd-Frank 913.

This is how the SEC construed Dodd-Frank 913 when it promulgated Regulation Best Interest in 2019. It relied mainly on the rulemaking authority in Dodd-Frank 913(f) and limited the regulation with language on recommendations of a securities transaction, retail investors, disclosure, and materiality. For one particular provision, the SEC invoked subsection 15(l)(2), which is identical to the companion subsection 211(h)(2), for a narrow exception requiring the elimination rather than disclosure of certain specified practices. The SEC explained and justified the exception on the ground that the specified practices created too strong an incentive for BD personnel to make a recommendation that would put their financial interests ahead of the interests of a retail customer.

The Regulation Best Interest precedent confirms that the legal approach for the Proposal is not reasonable. The SEC should not, as it did in the Proposal, construe subsection 211(h)(2) as an independent source of general rulemaking power, unconnected to the limiting words in Dodd-Frank 913 and sections 211(g) and 211(h)(1), to prohibit or restrict the conduct of IAs (or BDs). The SEC seized the broadest and severest possible rulemaking power and made the carefully wrought provisions in other parts of sections 15 and 211 superfluous. As understood by the SEC, subsection 211(h)(2) means that the agency has not ever had to comply with sections 211(g) and 211(h)(1) and has never needed to give effect to Congress’s words “personalized investment advice,” “retail customer,” “recommendation,” “material conflicts of interest,” and “disclosure.” The SEC would have been able to use section 211(h)(2) to regulate narrow or broad conduct of IAs and BDs on sales and compensation practices and conflicts of interest. The SEC would have been able to use subsection 15(l)(2) similarly, but instead it used Dodd-Frank 913(f) for Regulation Best Interest and relied on subsection 15(l)(2) specifically for a narrow exception.

If Congress had meant to give the SEC unconstrained rulemaking power to prohibit or restrict conduct of BDs and IAs, it would have enacted sections 15(l)(2) and 211(h)(2) alone and would not have led with the other provisions in sections 15 and 211. That is not what Congress did. The Proposal’s interpretation flouts Congress’s will.

Conclusion

The SEC’s use of subsections 15(l)(2) and 211(h)(2) as the statutory authority for the Proposal did not reflect a balanced or objective effort to determine the best understanding of Congress’s meaning. Those subsections are subordinate to sections 15(k), 15(l)(1), 211(g), and 211(h)(1), as well as the limiting language that recurs throughout Dodd-Frank 913. Instead, the SEC ignored the statutory limitations and treated the two subsections as free-standing authority for a far-reaching proposal of detailed and intrusive rules to govern and restrict the way BDs and IAs employ technological innovation. The structure and context of the statutes surrounding the two subsections on which the SEC relied show that Congress did not grant the rulemaking power the SEC grabbed.

In our system, courts are a back-stop to this kind of agency behavior, but the system of government and the country would be better off if agencies themselves took on more responsibility for staying well within the boundaries of statutory authority. The SEC should not pursue the Proposal and instead should continue to address BD and IA conflicts of interest, including any presented by the use of technology, with Regulation Best Interest and the many other regulatory controls it cited in the Proposal and currently has available.

Citations and endnotes are not included in the web version of this product. For complete citations and endnotes, please refer to the downloadable PDF at the top of the webpage.