Beyond the Hype: The SEC's Intensified Focus on AI Washing Practices

The U.S. Securities and Exchange Commission (SEC) is cracking down on how firms promote their artificial intelligence (AI) technologies to protect investors from falling victim to "AI-washing." On March 18, 2024, the SEC charged two investment advisors, Delphia (USA) Inc. and Global Predictions Inc., with making false and misleading statements regarding their use of AI. The SEC also charged Delphia and Global Predictions with violating the Marketing Rule.

Both firms advertised that they were using AI in their investment processes, but neither had the AI capabilities they claimed to have. Global Predictions touted that it was the "first regulated AI financial advisor" and that it provided "[e]xpert AI-driven forecasts." Delphia, a robo-advisor business, claimed that it used AI to analyze client data "to make intelligent investment decisions" and "predict which companies and trends are about to make it big." In an SEC examination in July 2021, Delphia admitted that it had not created an algorithm to analyze client data. In October 2021, Delphia took further actions to correct misstatements regarding its use of client data, informing the SEC that it would review all marketing and regulatory disclosure documents and telling certain investors it was not using client data for its algorithm "because it had not yet collected enough client data to provide meaningful insights." Nonetheless, Delphia continued to mislead current and prospective clients in various marketing statements about its "proprietary algorithm" through August 2023. For example, Delphia advertised it was using client data to train "[its] algorithm for pursuing even better returns" and that its investing algorithm could "make predictions across thousands of publicly traded companies up to two years into the future." To settle the charges with the SEC, Delphia agreed to pay a civil penalty of $225,000, and Global Predictions agreed to pay a civil penalty of $175,000. A spokesperson for Global Predictions stated that the firm has now "clarified across our marketing how exactly we use AI."

What is AI Washing?

The SEC has coined the term "AI washing" to describe deceptive practices where firms embellish or exaggerate their use of AI and its capabilities to attract investors by creating a façade of innovation and reliability. Just as greenwashing involves misleading claims of environmental consciousness, firms use AI washing to differentiate themselves from competitors and lure investors with their allegedly cutting-edge AI technology and superior performance. This practice may manifest in various forms such as overstating the capabilities of AI algorithms, misrepresenting the level of human involvement in decision-making processes or making misleading claims about the performance of AI-driven products or services.

This is the SEC's first-ever enforcement action for AI washing. In the SEC press release, Director of the SEC's Division of Enforcement Gurbir Grewal emphasized that the SEC is committed to protecting investors from AI washing as "more and more investors consider using AI tools in making their investment decisions or deciding to invest in companies claiming to harness its transformational power." If investment firms claim to use AI in their investment processes, they must ensure those representations are not false or misleading. While this action specifically targeted investment advisors, the SEC is watching other players in the investment industry. As SEC Chairman Gary Gensler stated in an educational video on the practice of AI washing, broker-dealers "might want to tap into the excitement about AI by telling you that they're using this new technology to help you get a better return," and public company executives "might think that they will enhance their stock price by talking about their use of AI."

In the last year, firms have been rushing to capitalize on the hype around AI by overstating or promoting the use of AI in their investment products and systems – making these products and services seem more sophisticated than they actually are. According to Goldman Sachs analysts, the proportion of S&P 500 companies mentioning AI on earnings calls in the fourth quarter of 2023 hit an all-time high of 36 percent. With this background in mind, Grewal warned that firms are making claims about incorporating AI technology in their business "before the firms actually develop the technology or the strategy or maybe they'll fail altogether to follow through on implementing the technology or the strategy after announcing it."

In January 2024, the SEC issued an investor alert on AI and investment fraud, discussing the growing concern with bad actors exploiting the AI hype to manipulate markets and deceive investors. The SEC states that investors should be wary of individuals and firms promoting AI products and services with promises of better, guaranteed returns and using sophisticated AI algorithms to provide investment advice ("Our proprietary AI trading system can't lose!" or "Use AI to Pick Guaranteed Stock Winners!"). While investing in companies that claim to be leaders in developing or using AI-powered systems may be exciting, the SEC cautions that "bad actors often use the hype around new technological development, like AI or crypto assets, to lure investors into schemes." Recent examples show that regulators are closely scrutinizing and penalizing firms for luring investors with false promises about their AI systems – in one case, Connecticut regulators ordered an investment firm to pay a civil penalty of $700,00 for fraudulently promising massive returns with its AI trading system that "operates 24 hours a day, so you never lose money."

AI holds great promise for improving efficiency and decision-making in the financial sector. Yet, this technology is also error-prone, sometimes generating information based on inaccurate, incomplete or outdated data. Even with accurate and current input, AI products or services can be faulty and "hallucinate," generating completely made-up information. The SEC's recent scrutiny of AI washing practices underscores the importance of transparency and accountability in adopting and deploying AI-powered products and services within the financial sector.

Key Takeaways

• Transparency: Firms must accurately represent and disclose the specifics of their AI systems in communications with investors to ensure clarity and dispel misconceptions surrounding AI capabilities in financial services. Firms should use terminology that accurately conveys how the AI technology works, considering what assumptions clients, investors and/or the public may rely on regarding how the technology works.
• Reviewing Marketing Materials with Increased Vigilance: As AI continues to evolve and play an increasingly prominent role in trading and investing, firms must use precise language when promoting their AI products and services. Firms should be vigilant in reviewing all marketing materials to update these claims, checking whether their claims can be substantiated or whether claims are no longer accurate in light of technology changes. This includes reviewing direct communications to investors via email, as well as statements on firm websites and social media platforms.
• Proactive Engagement and Adopting Best Practices: Firms should consider adopting best practices in the deployment of AI-driven solutions. Despite the complexities of AI integration, firms can promote accountability and uphold the integrity of their AI applications by addressing the limitations or risks of their AI products.

The Holland & Knight SECond Opinions Blog will continue to monitor these and other developments and provide updates. If you need further information on this topic – or anything related to SEC enforcement or internal investigations – please contact the authors or another member of Holland & Knight's Securities Enforcement Defense Team.