The investment management industry has been abuzz with the potential of artificial intelligence (AI) to revolutionize investment operations. However, the SEC charges announced in March 2024 against two investment advisers serve as a wake-up call, highlighting the dark side of making false or misleading claims about the use of AI. 

As the adoption of AI continues to surge across the financial sector, investment management firms must approach it with transparency and integrity. The temptation to engage in “AI washing” – the practice of exaggerating or misrepresenting the capabilities of AI – is not acceptable from a regulatory standpoint. 

The Securities and Exchange Commission (SEC) plays a vital role in ensuring registrants adhere to fair and ethical practices within the investment management industry. The cases of Delphia (USA) Inc. and Global Predictions Inc. underscore the SEC’s commitment to holding firms accountable for any misleading statements, especially when it comes to the use of AI. 

So, let’s talk about what happened with Delphia (USA) Inc. and Global Predictions Inc., the potential implications for the investment management industry, and the importance of maintaining a responsible and transparent approach to AI adoption. 

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So, what happened? 

Two prominent financial advising firms, Delphia (USA) Inc. and Global Predictions Inc., found themselves in the regulatory spotlight for their deceptive claims surrounding the use of AI in their operations. 

The SEC’s charges against Delphia and Global Predictions recognize a broader trend of increased scrutiny on the intersection of AI and financial services. Let’s analyze what went wrong: 

  • False and Misleading Statements: Delphia and Global Predictions were charged with making false and misleading statements about their utilization of AI and machine learning algorithms in their investment strategies. The SEC found that these companies exaggerated or misrepresented their AI capabilities on their websites and social media platforms. 
  • Penalties Imposed: In total, the two firms agreed to pay $400,000 in penalties to settle the charges brought by the SEC, Delphia will pay $225,000 while Global Predictions will pay $175,000. 
  • Importance of Transparency: Gurbir S. Grewal, director of the SEC’s Division of Enforcement, emphasized the significance of protecting investors against “AI washing.” He stressed that firms claiming to use AI in their investment processes must ensure that their representations are accurate and not misleading. 
  • Admission and Settlement: Neither Delphia nor Global Predictions admitted or denied the SEC’s findings. Instead, they opted to settle the charges, signaling a recognition of the importance of compliance with regulatory standards. 
  • Revised Marketing Approach: Both companies have taken steps to properly disclose their actual use of AI in response to the SEC’s actions. Delphia, for example, updated its website to indicate potential future AI activity rather than overstating current capabilities.  
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To avoid ending up in the same situation as Delphia and Global Predictions, it is crucial for companies to uphold the principles of transparency, integrity, and ethical conduct.  

Reasons and Consequences of Overstating AI Capabilities 

Why are organizations making false claims about their use of AI? What are they getting out of it? Is it that AI is so cool and innovative, and they want to come across that way, too? Driven by competition and the pursuit of innovation, the hope of portraying oneself as at the forefront of technological advancement can be enticing. However, the risks associated with overstating AI capabilities in investment management are clearly serious.  

Potential Consequences: 

  • Investor Harm: Misleading investors about the extent of AI integration in investment strategies can lead to financial harm. Investors may make decisions based on false premises, leading to losses or missed opportunities.  
  • Reputational Damage: Trust is the foundation of any successful investment advisory firm. Exaggerated claims about AI capabilities can erode trust and damage the firm’s reputation in the eyes of clients, investors, and regulators.  
  • Regulatory Penalties: As demonstrated by the SEC’s enforcement actions against Delphia and Global Predictions, regulatory bodies are actively monitoring and cracking down on deceptive practices related to AI. Firms found guilty of misleading investors may face significant penalties, not only in terms of monetary fines but also in terms of regulatory restrictions and oversight. 

To use AI properly, firms must practice credibility and integrity, as the risks of overstating AI capabilities far outweigh any perceived benefits. Investment advisory firms must prioritize transparency, accuracy, and ethical conduct in their communication and implementation of AI technologies. As a result, they will protect their firm from reputational damage and eroding trust among investors and stakeholders.  

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Regulatory Concerns 

In recent examinations, the SEC has placed particular emphasis on compliance concerns related to AI integration in the investment processes, focusing on several key areas. 

  • Use of Information Obtained through AI in the Investment Process: One of the primary concerns raised by the SEC revolves around the utilization of information obtained through AI algorithms in the investment decision-making process. Firms are expected to demonstrate diligence in assessing the accuracy, reliability, legality, and relevance of data and information flows entering their firm, in this scenario, those generated by AI systems. 
  • Confidentiality and Privacy Concerns: Confidentiality and privacy are essential considerations in AI technologies, particularly concerning the handling and protection of sensitive and confidential information and work products. The SEC seeks to understand where the information provided to AI systems is stored, how it is housed and protected, whether it is shared with third parties, and how it is used for training the system. 
  • Material Non-Public Information (MNPI) Concerns: The SEC is vigilant in monitoring the handling of material non-public information (MNPI) in the context of AI usage. Firms must demonstrate strong infrastructure and operational controls to prevent unauthorized access or misuse of MNPI, particularly in quantitative strategies where AI algorithms play a significant role.  
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Best Practices for Transparency and Disclosure 

Transparent and accurate disclosures regarding the use of AI in investment strategies are essential for maintaining trust and credibility with investors and clients. But also, it’s critical to adhere to SEC regulations. These disclosures provide clarity on how AI technologies are used, the extent of their integration, and the potential impact of investment decisions.  

Guidelines for Comprehensive Disclosures: 

  1. Be Specific and Detailed: Disclosures should clearly outline the role of AI in investment processes, including how algorithms are developed, trained, and implemented. Provide specific examples of how AI is used to analyze data, identify trends, and inform investment decisions. 
  2. Explain Limitations and Risks: Acknowledge the limitations of AI technologies and the inherent risks associated with their use. Highlight potential pitfalls, such as algorithm biases, data inaccuracies, and model uncertainties, and explain how these risks are  
  3. Define Performance Metrics: Clearly define the metrics used to evaluate the performance of AI-driven investment strategies. Provide historical data and benchmarks to demonstrate the effectiveness and reliability of AI models in generating returns.  
  4. Address Ethical Considerations: Discuss the ethical principles guiding the use of AI in investment management, such as fairness, accountability, and transparency. Explain how ethical considerations are integrated into AI development and decision-making processes.  
  5. Offer Accessibility and Clarity: Disclosures must be written in plain language and are easily accessible to investors and potential clients. Avoid technical terminology that may obscure understanding and provide supplementary materials or resources for further clarification if needed.  

Parting Insights 

Moral of the story? The SEC enforcement actions against Delphia and Global Predictions serve as a stark reminder of the importance of transparency and integrity when it comes to the use of AI in investment management. As the adoption of AI continues to accelerate, Investment advisory firms must prioritize ethical practices, robust governance frameworks, and ongoing compliance efforts. 

*Disclaimer: This blog post is for informational purposes only and does not constitute legal advice. The discussion of the SEC’s actions against Delphia and Global Predictions serves as a cautionary example, not as a substitute for professional legal counsel tailored to your specific situation.