Investment Advisors Pay $400,000 in Civil Penalties to Settle AI Fraud Case

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Robot sitting in a courtroom, representation of AI Fraud

On March 18, 2024, Delphia Inc. and Global Predictions Inc. paid $400,000 in civil penalties to settle SEC charges related to the two investment advisers misrepresenting the method by which they used artificial intelligence (AI) to support their efforts. The firms were each found to be in violation of the Advisers Act and the SEC‘s Marketing rule as a result of the fraudulent AI statements they made.

Delphia Inc. is based in Toronto and engaged in AI fraud from 2019 until this past year. During these four years, the firm publicly announced and stated in SEC filings that it underwent an innovative process, fueled by AI, that allowed the firm to predict which investments would have large returns for their clients before others. Although Delphia collected certain pieces of data from clients, they did not use this data as inputs for investing algorithms as they claimed, nor did they have access to any algorithm of the sort.

The SEC conducted an audit on Delphia in 2021 and discovered the firm had been misleading its clients in this manner. In an attempt to remedy the issue, Delphia hired internal and external compliance officers. However, despite these efforts, Delphia continued to commit AI fraud, making false claims about their AI use in advertisements.

False Statements About AI Fraud

Further, in 2023, Global Predictions engaged in similar behavior, posting false or misleading statements about their use of AI on their website, social media accounts, and in their SEC filings. Specifically, Global Predictions stated that they were “the first regulated AI advisor” and that they employed “expert AI-driven forecasts.” The company expanded its AI fraud scheme to include false claims that they offered investors tax-loss harvesting services from which investors could benefit.

The SEC also noted that Global Predictions violated the SEC Marketing rule as the firm posted testimonials related to their services on their websites and failed to disclose the individuals giving testimonials conflicts of interest. In further violation of the marketing rule, the firm advertised a hypothetical performance of their services on several platforms but did include a disclaimer that it was a hypothetical performance.

Gurbir S. Grewal, Director of the SEC’s Division of Enforcement spoke to the importance of safeguarding investors from this type of behavior and noted, “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, we are committed to protecting them against those engaged in ‘AI washing. As today’s enforcement actions make clear to the investment industry – if you claim to use AI in your investment processes, you need to ensure that your representations are not false or misleading. And public issuers making claims about their AI adoption must also remain vigilant about similar misstatements that may be material to individuals’ investing decisions.”

What is the Advisers Act and how does it protect against AI fraud?

The Advisers Act, officially known as the Investment Advisers Act of 1940, primarily aims to protect investors by regulating investment advisers. The Act focuses broadly on regulating investment advisers and their interactions with clients, ensuring they act in their clients’ best interests and disclose any potential conflicts of interest.AI fraud can fall under broader categories of securities fraud and deceptive practices, which the Act does address.

Overall, while the Advisers Act may not specifically mention AI fraud, its provisions regarding investor protection, transparency, and prohibition of fraudulent activities can indirectly address fraudulent behavior involving AI in investment advising. As AI continues to play a larger role in financial markets, regulatory bodies like the SEC may develop more specific guidelines or regulations to address emerging issues related to AI fraud.

How does the SEC Marketing rule protect against AI fraud?

While the SEC’s marketing rule doesn’t explicitly address AI claims, it does establish principles and guidelines aimed at preventing fraudulent or misleading advertising practices in the investment advisory industry. These principles can indirectly help protect against firms making fraudulent AI claims by ensuring that all marketing materials are accurate, truthful, and not misleading. Here are the seven principles of the SEC’s marketing rule:

  1. Prohibition of False or Misleading Statements

    Investment advisers are prohibited from making any false or misleading statements in their advertisements.

  2. Prohibition of Past Specific Recommendations

    Advertisements cannot include any testimonials or statements concerning specific investment advice that was profitable unless certain conditions are met.

  3. Presentation of Specific Investment Advice

    If specific investment advice is presented, the advertisement must include a list of all recommendations made by the adviser over the preceding period, as well as other information about the adviser’s practices.

  4. Preventing Cherry-Picking

    Advertisements must disclose any selection criteria used to determine which recommendations were included in the presentation and which were excluded.

  5. Reasonable Basis

    Advertisements must have a reasonable basis for any claims made, and any risks associated with the advice must be adequately disclosed.

  6. Fair and Balanced Presentation

    Advertisements must present information in a fair and balanced manner, avoiding the omission of material information that could render the advertisement misleading.

  7. Pre-Approval by a Designated Employee

    Advertisements must be reviewed and approved in writing by a designated employee of the investment adviser firm before being disseminated.

These principles aim to ensure that investors receive accurate and non-misleading information about investment opportunities and the services offered by investment advisers. While the SEC’s marketing rule does not specifically address AI claims, adherence to these principles can indirectly help prevent firms from making fraudulent or misleading claims about AI-related investment strategies or technologies. For example, if an investment adviser were to use AI in their investment process and advertise its benefits, they would need to ensure that any claims made about the AI’s performance are accurate and supported by evidence, and that the associated risks are adequately disclosed to investors.

Failure to comply with the SEC’s marketing rule could result in enforcement actions by the SEC and other regulatory consequences.