How Does the SEC Define a Conflicted Transaction in Its Proposed Rules?

Concept

The Securities and Exchange Commission’s proposed rules frame a conflicted transaction through the lens of technological architecture, specifically targeting the use of predictive data analytics (PDA) and artificial intelligence (AI) by broker-dealers and investment advisers. The core of the definition rests on a simple, yet powerful, principle ▴ a conflict arises when a firm’s technology-driven investor interaction places the firm’s interests ahead of the investor’s interests. This perspective moves the analysis of conflicts beyond simple compensation structures and into the very logic of the systems firms use to engage with their clients. The SEC’s concern is that these sophisticated analytical tools can be engineered to optimize for firm revenue or to subtly guide investor behavior in ways that benefit the firm, potentially to the investor’s detriment.

At its heart, the proposed framework identifies a “conflicted transaction” not by a single event, but as the outcome of a system. The conflict is embedded within the design and deployment of “covered technology” used in investor interactions. The SEC is particularly focused on “black box” algorithms where the firm itself may not fully comprehend how the technology arrives at a specific recommendation or output. This introduces a new vector of systemic risk.

The potential for corrupted data, inherent biases, or the exponential scaling of even minor conflicts are central to the SEC’s rationale. Therefore, the definition of a conflicted transaction is inextricably linked to the technology that facilitates it and the potential for that technology to prioritize the firm’s financial success over the client’s financial well-being.

A conflicted transaction under the SEC’s proposal occurs when a firm’s use of predictive data analytics in client interactions prioritizes its own interests over those of the investor.

It is important to note that a recent development has seen the withdrawal of these proposed rules. On June 12, 2025, the SEC withdrew 14 proposed regulations, including the one concerning conflicts of interest associated with predictive data analytics. This action signals a significant shift in regulatory priorities, and any future rulemaking in this area would necessitate restarting the entire process. Despite the withdrawal, the underlying principles and the definition of a technology-driven conflict remain a critical area of focus for understanding the future direction of financial regulation.

Strategy

The strategic imperative for broker-dealers and investment advisers under the now-withdrawn proposed rules was to re-architect their compliance and operational frameworks. The focus was a shift from disclosure-based mitigation to a more robust system of identification and elimination or neutralization of technology-driven conflicts. A firm’s strategy would have needed to revolve around a comprehensive, documented process for evaluating any covered technology before and during its implementation.

How Would Firms Need to Adapt Their Policies?

Firms would have been required to adopt and implement written policies and procedures designed to achieve compliance with the proposed rules. This would involve creating a systematic process to evaluate the use, or potential use, of any covered technology in investor interactions. The core of this strategy is pre-emptive analysis. Before a new AI-driven tool or predictive analytic model is deployed, it would have to be scrutinized for potential conflicts of interest.

This requires a deep understanding of how the technology functions, the data it uses, and the outcomes it is designed to achieve. The strategy is one of proactive system design, where compliance is built into the technology lifecycle.

The proposed rules would have mandated that firms create and maintain a detailed written record of their evaluation of any conflict of interest related to covered technology.

The proposed rules also contained a significant record-keeping component. Firms would have been required to maintain extensive documentation of their evaluation of any conflict of interest. This documentation serves as a verifiable audit trail, demonstrating that the firm has a robust process for identifying and addressing conflicts. This creates a strategic need for integrated compliance systems that can track the evaluation, implementation, and ongoing monitoring of all investor-facing technologies.

A Comparative Look at Conflict Management

The table below illustrates the strategic shift from a traditional, disclosure-oriented approach to the technology-focused framework of the proposed rules.

This strategic realignment underscores the SEC’s growing concern with the systemic risks posed by advanced technologies in the financial sector. While the rules have been withdrawn, the underlying strategic considerations for firms remain relevant. A proactive, systems-based approach to managing technology-driven conflicts is a prudent strategy for mitigating regulatory and reputational risk.

Execution

Executing a compliance framework under the SEC’s proposed rules would have required a granular, multi-stage process. This process moves from initial identification through to ongoing monitoring and documentation, creating a continuous loop of compliance activity. The execution is fundamentally about operationalizing the strategic decision to build compliance into the firm’s technological architecture.

A Procedural Guide for Compliance

A firm’s execution of the proposed rules would necessitate a clear, actionable set of procedures. The following list outlines a potential operational playbook for a firm seeking to comply with the proposed framework:

1. Technology Inventory and Classification ▴ The first step is to create a comprehensive inventory of all technologies used in investor interactions. Each technology must then be classified as a “covered technology” under the rule’s definition, focusing on those that use predictive data analytics or similar AI-driven functionalities.
2. Conflict Identification Protocol ▴ For each covered technology, a formal conflict identification protocol must be established. This involves a multi-disciplinary team, including compliance, legal, and technology specialists, to analyze how the technology functions and identify any instances where it could prioritize the firm’s interests.
3. Elimination or Neutralization Plan ▴ Once a conflict is identified that places the firm’s interests ahead of the investor’s, a plan must be developed to “promptly” eliminate or neutralize its effect. This could involve modifying the algorithm, altering the data inputs, or implementing system-level controls to counteract the conflict.
4. Documentation and Record-Keeping ▴ Every stage of this process, from the initial evaluation to the final resolution, must be meticulously documented. This creates the required audit trail and demonstrates a systematic approach to compliance.
5. Ongoing Monitoring and Testing ▴ Compliance is not a one-time event. Firms must establish a schedule for the periodic review and testing of all covered technologies to ensure they remain compliant and to identify any new conflicts that may emerge over time.

Hypothetical Conflict Analysis

To illustrate the execution process, consider a hypothetical scenario where a broker-dealer uses an AI-powered platform to recommend investment products to retail investors. The table below details how a potential conflict would be analyzed and addressed under the proposed rules.

The core of execution under the proposed rules would be a documented, systematic process for identifying and neutralizing conflicts embedded within a firm’s technology.

Even with the withdrawal of the proposed rules, this execution framework remains a valuable model for firms seeking to build robust, ethical, and defensible technology platforms. The principles of proactive identification, neutralization, and documentation are central to sound risk management in an increasingly technology-driven financial landscape.

Reflection

The SEC’s withdrawn proposal on conflicted transactions provides a clear trajectory for future regulatory thinking. The core principles it established, centered on the systemic risks embedded within financial technology, compel a deeper consideration of a firm’s operational architecture. How resilient is your current compliance framework to the challenges posed by increasingly complex, opaque algorithms? The exercise of mapping your firm’s investor-facing technology and subjecting it to the rigorous analysis demanded by the proposal is a valuable undertaking.

It moves compliance from a reactive, disclosure-based function to a proactive, integrated system of risk management. The ultimate question is whether your firm’s technological infrastructure is designed not just for performance, but for verifiable integrity.