In August, the SEC proposed rules requiring broker-dealers (BDs) and investment advisers (IAs) to identify and eliminate or neutralize the effect of conflicts of interest associated with their use of technologies, widely defined (Proposal). My primary concern about the Proposal is that it goes beyond the limited aims Congress set for the SEC in the statutory provisions the SEC used as authority for the rulemaking.
Under the proposed rules, BDs and IAs would need to review and evaluate technologies, such as artificial intelligence, machine learning, and predictive data analytics, used with customers or investors. If a feature of a technical system puts the interest of the BD or IA ahead of the interests of an investor, for example, automated messages that encourage an investor to trade too much or keep too many assets in an advisory account, the feature would need to be eliminated or neutralized.
An agency such as the SEC must have statutory authority to propose and adopt a legislative rule. It therefore needs to read and construe the relevant statutes to determine whether Congress authorized the rulemaking. The agency has a responsibility, just as a court does, to be a faithful agent of Congress and a steward of Congress’ 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.
The SEC invoked subsection 211(h)(2) of the Investment Advisers Act as authority for the Proposal. The provision 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. The SEC also relied on subsection 15(l)(2) of the Securities Exchange Act, but it is identical to subsection 211(h)(2). For simplicity, I will refer only to subsection 211(h)(2).
The SEC treated that one provision as an independent source of general rulemaking power to prohibit or restrict the conduct of IAs and BDs and disregarded words of limitation on the SEC’s power that Congress included in accompanying enactments. That approach is contrary to the Supreme Court’s normal method of determining an agency’s rulemaking power. The Court examines the text and context of the relevant statute with a view to its place in the overall statutory scheme and does not restrict its analysis to a particular statutory provision in isolation.
Subsection 211(h)(2) should not be considered alone and out of context. It was 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’ choices and boundaries.
A fair reading of the entirety of Dodd-Frank 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. A section added right before section 211(h), section 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.”
The Proposal disregarded these essential limitations. It 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. The Proposal did not attend to the emphasis on retail customers in Dodd-Frank 913. For instance, investors for an IA would include institutional clients.
The SEC avoided the limiting language in Dodd-Frank 913 by isolating and taking out of context one small part of the amendments. Subsection 211(h)(2) 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. The SEC Chair articulated this broad view of subsection 211(h)(2) in his statement on new rules for advisers to private funds, specifically noting that Congress did not confine subsection 211(h)(2) to retail investors.
This is not the better reading of subsection 211(h)(2). 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 and investment recommendations in the rest of Dodd-Frank 913.
Section 211(h) follows 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. Section 211(h) links directly to section 211(g) and its more detailed and limited rulemaking power.
An appropriate reading of subsection 211(h)(2) is that the SEC was first to address the major issues of the standards of conduct of BDs and IAs under 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. That is how the SEC interpreted the BD companion to subsection 211(h)(2) in another rulemaking.
In addition, the SEC’s broad construction of subsection 211(h)(2) was not reasonable because it made the other rulemaking provisions in Dodd-Frank 913 superfluous. Under its understanding, the SEC may use subsection 211(h)(2) to regulate conflicts of interest of IAs and BDs without complying with any of the other words of limitation in Dodd-Frank 913. If Congress had meant to give the SEC unconstrained rulemaking power to prohibit or restrict conduct of BDs and IAs, it would have enacted subsection 211(h)(2) alone and would not have started with the other, more restrictive rulemaking provisions in section 211. That is not what Congress did, showing that subsection 211(h)(2) follows from and is subservient to the preceding parts of section 211. The Proposal’s interpretation flouted Congress’s will.
The SEC’s use of subsection 211(h)(2) for the Proposal did not reflect a balanced or objective effort to determine the best understanding of Congress’ meaning. Subsection 211(h)(2) is subordinate to the limiting language that recurs throughout Dodd-Frank 913. Instead, the SEC ignored the statutory limitations and treated the subsection 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 subsection on which the SEC relied show that Congress did not grant the rulemaking power the SEC grabbed.
This post comes to us from Andrew N. Vollmer, a senior affiliated scholar at the Mercatus Center at George Mason University, a former deputy general counsel of the Securities and Exchange Commission, and a former professor at the University of Virginia School of Law. It is based on his comment letter filed with the SEC and available here.