In the ever-evolving landscape of financial services, two firms, referred to here as Firm A and Firm B, recently found themselves in hot water with the Securities and Exchange Commission (SEC) for violations of fiduciary duty, the Marketing Rule 206(4)-1, and a practice known as “AI Washing”. This article will explore these violations and provide recommendations on how to avoid them.
VIOLATIONS
Firm A, a Delaware corporation with its principal place of business in San Francisco, California, violated its fiduciary duty by failing to provide advance notice of certain material changes to its advisory contract. The firm had the power to change the terms of the contract unilaterally without notifying the clients; in fact, the clients were told they had to go to the portal to see if there were any updates to the contract, which is a direct violation of its fiduciary duty as an investment adviser.
As an investment adviser, Firm A is obligated to act in the best interests of its clients. This includes providing advance notice of any material changes to its advisory contract. By failing to do so, Firm A did not give its clients the opportunity to review and understand these changes or to consider whether they might want to seek advice elsewhere.
Moreover, the firm’s practice of unilaterally changing the terms of the contract without notifying the clients is problematic. This approach does not align with the principles of transparency and fairness that underpin the fiduciary duty. Clients should not be expected to check a portal for updates to their contracts constantly. Instead, the firm should proactively communicate any changes to its clients.
In addition, the firm’s failure to obtain the client’s consent before making material changes to the contract is another breach of its fiduciary duty. Consent is a fundamental aspect of the client-adviser relationship. By making changes without the client’s knowledge or consent, the firm disregarded this important principle.
Firm A also violated Advisers Act Rule 206(4)-1, also known as the Marketing Rule. It advertised hypothetical performance on its public website without adopting and implementing the policies and procedures required by this rule. Furthermore, the firm failed to implement certain of its compliance policies and procedures relating to its marketing activities.
For reference, when advertising hypothetical performance, the Marketing Rule indicates that firms should:
Create, adopt, and implement policies and procedures reasonably designed to ensure that the hypothetical performance information is relevant to the likely financial situation and investment objectives of the advertisement's intended audience.
Not use hypothetical performance in advertisements distributed to a mass audience or intended for general circulation because it would not be reasonable to be able to form any expectations about the financial situation and investment objectives of a mass audience.
Assess the prospect to determine that they have the resources and financial expertise to consider the hypothetical information being provided appropriately.
Provide all the relevant information to allow the intended audience to understand the criteria used and assumptions made in calculating the hypothetical performance, including any assumptions that future events will occur.
Provide disclosures around the risks and limitations of using hypothetical performance in making investment decisions.
Lastly, Firm A misled investors about its use of artificial intelligence (AI), claiming to be the “first regulated AI financial advisor.” However, it made false and misleading claims about its AI capabilities and the services it offered. They stated that it made allocation recommendations utilizing algorithms and stated on its website that their technology incorporated expert AI-driven forecasts. Neither of these claims was substantiated. They also were not able to substantiate performance claims upon demand by the Commission.
In addition they also claimed to have more than $6 billion of assets on its platform when, in fact, they did not report any regulatory assets under management on their Form ADV.
Disseminated testimonials on their public website without describing material conflicts of interest in their relationship with those providing testimonials, such as family members and independent contractors.
Their compliance manual required the review and approval of all marketing materials in writing and to maintain a log of any such approvals. It also prohibited the use of employees’ personal social media to promote the firm and required the review and approval of any posting, liking or sharing of any third-party content on the firm’s social media account. They failed to implement any of these policies and procedures.
They had to pay $175,000 in civil money penalties
They do not report any Regulatory Assets Under Management
MORE VIOLATIONS
Firm B, a Delaware corporation with its principal place of business in Toronto, Canada, made false and misleading statements in its regulatory filings, advertisements, and social media relating to its purported use of artificial intelligence and machine learning. Despite updating its disclosures to state that it did not use client data in its investment process, Firm B continued to make false and misleading statements about its use of AI and machine learning.
They intended to use artificial intelligence and machine learning to collect data from their clients (such as from social media, banking, credit cards, online purchases, etc.) as inputs into their algorithms. They never accomplished this goal. While they did collect certain client data intermittently between 2019 and 2023, it never used that data with artificial intelligence or machine learning or otherwise used that data in any way as inputs into its investing algorithms.
After making the disclosure changes in 2021, after an examination, the SEC indicated that they still continued to make certain false and misleading statements in advertisements regarding the use of client data in various formats through August 2023
Firm B was also charged with violating the Marketing Rule, which prohibits a registered investment adviser from disseminating any advertisement that includes any untrue statement of material fact. The firm made false and misleading statements regarding its purported use of AI and machine learning that incorporated client data in its investment process. For example, investors who joined the firm in 2021 and 2022 were sent an email communication stating that their data was “helping them train their algorithm for pursuing ever better returns.” and that they “will pool your data with everyone else’s to power our algorithm.”
In addition, they “failed to adopt and implement policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder. Specifically, they failed to adopt and implement policies necessary to ensure that advertisements that they published, circulated, or distributed were accurate and did not contain misleading or untrue statements. While they did have some advertising policies and procedures, it lacked policies and procedures relating to social media. Further, they had a number of employees and consultants involved in their advertising review and approval process. They failed to lay out a clear advertising review and approval process, either in its policies and procedures or otherwise, that would enable its personnel and consultants to understand their respective roles and responsibilities in that process.
They had to pay $225,000 as a civil money penalty.
RECOMMENDATIONS
To avoid these pitfalls, firms should always communicate any material changes to their clients well in advance. Including any changes to the advisory agreement. They should also ensure that any changes are made with the client’s best interests in mind and not just for the firm’s benefit.
Firms should ensure they have robust policies and procedures in place for their marketing activities. They should also regularly review and update these policies to ensure they are in line with current regulations. These policies should be tested at least annually to ensure that what is outlined in the policies and procedures aligns with actual practices. The Chief Compliance Officer (CCO) should have a seat at every table, enabling a clear understanding of all actions taken, ideally before they are executed. This proactive involvement allows the CCO to act as a Compliance Project Manager, helping to prevent such issues from arising.
A thorough understanding of the firm’s technology and its implementation, along with awareness of potential conflicts and methods to mitigate or disclose those conflicts, is critical for any firm. While using the latest technological jargon may seem like a good marketing strategy, it is essential to ensure that any claims made in advertising or disclosures are implemented as stated.
Firms often implement changes or have plans to do so especially operational changes. However, it is crucial not to advertise or disclose these changes until they have been fully implemented. Conversely, changes to a client's advisory agreement, fees, etc., should be disclosed only after obtaining client consent and implementation.
DISCLAIMER
All information provided is for educational purposes and shall not be construed as specific advice. The information does not reflect the view of any regulatory body, State or Federal Agency or Association. All efforts have been made to report true and accurate information. However, the information could become materially inaccurate without warning. Not all information from third-party sources can be thoroughly vetted. Coulter Strategic Services and its staff do NOT provide legal opinions or legal recommendations. Nothing in this material should be considered as legal advice or opinion. If you would like specific compliance education, training, and services to help with your compliance program or project, please contact Coulter Strategic Services.
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