SEBI on the Reporting of Artificial Intelligence and Machine Learning Systems

Introduction

The Securities & Exchange Board of India released three circulars[1], on the 4^th of January, 31^st of January and most recently 9^th of May owing to the increased usage of Artificial Intelligence & Machine Learning (AI & ML) Systems as product offerings. The Circulars increased reporting requirements for Market Intermediaries (MIs), Market Infrastructure Institutions (MIIs), Mutual Funds (MFs), while being labelled as a survey and the creation of an inventory of the landscape of such technology, to gain an in-depth understanding and ensure preparedness for AI/ML policies in the future.

Recognising that most AI/ML systems are black-boxes, i.e they can be viewed in terms of their inputs and outputs, without any knowledge of their internal workings,[2] SEBI warned intermediaries against misrepresenting the benefits of any financial products involving the use of AI & ML Technologies.

Scope

The SEBI has kept the definition of such systems amply wide, by including within the scope of the circular, any applications or systems that are offered to investors or used internally, to:

• Facilitate investing and trading or any other purpose; or
• Disseminating investment strategies and advice; or
• Carrying out compliance/ operations/ activities.

The circular also covers all Fin-tech and Reg-tech initiatives involving AI/ML undertaken by market participants.

Annexure B to the Circular gives a detailed list of systems which would be deemed to be based on AI & ML Technologies. The list includes the following systems:

1. Natural Language Processing, Sentiment Analysis, Text Mining etc.
2. Neural Networks and their modified forms
3. Supervised or Unsupervised ML Systems
4. Statistical Heuristic Methods (instead of procedural algorithms)
5. Systems using feedback mechanisms to improve their parameters
6. Systems doing Knowledge Representation and maintaining Knowledge Bases.

Regulatory Requirements

The Circulars call for all MIs, MIIs and MFs to make quarterly submissions to the Stock Exchanges/ Depositories, SEBI directly and to the Association of Mutual Funds in India respectively, which in the first and third cases would subsequently submit a consolidated quarterly report to SEBI, while maintaining the confidentiality of the information received.

Annexure A to the Circular contains the form that must be filled by the respective stakeholders using AI/ML Technologies. It contains Yes/No questions about:

1. Involvement of order initiation, routing and execution.
2. Dissemination of investment trading advice or strategy.
3. Use in the area of Cyber Security to detect attacks.
4. Inclusion in the scope of System Audit, if applicable.

Furthermore, the form contains free text questions on the following points: 

1. Type of Area where AI/ML is used.
2. How was the AI/ML project implemented (internally/through solution provider/jointly)
3. Compliance of key controls and control points with SEBI circular on cyber security control requirements.
4. Description of the system and how it uses AI/ML.
5. Safeguards to prevent abnormal behavior of such systems.
6. Any adverse comments in the system audit regarding the AI/ML system.

Analysis

With statistics like the Research and Markets prediction that the Global algorithmic trading market would grow at a CAGR of 10.36% during the period 2018-2022,[1] the use of AI/ML in Financial markets is expected to grow rapidly in the near future. Proactive Regulators tend to assume from expeditious growth in any sector that regulation and reporting is called for. While its benefits include investor protection and the prevention of financial crimes, the debate around these outweighing the costs is far from settled. 

The European Union in 2014 came up with a Directive on Markets in Financial Instruments[2], which imposed similar reporting requirements as the SEBI has sought to, with the circular.

US Federal Reserve Governor Lael Brainard, while discussing the regulation of AI in Financial Services writes: “ Regulation and supervision need to be thoughtfully designed so that they ensure risks are appropriately mitigated but do not stand in the way of responsible innovations that might expand access and convenience for consumers and small businesses or bring greater efficiency, risk detection, and accuracy.”[3]

She goes on to add from one of her previous speeches “Likewise, it is important not to drive responsible innovation away from supervised institutions and toward less regulated and more opaque spaces in the financial system.”[4] Some legal scholars have also expressed views like, a granular regulation scheme of AI transparency will likely bring new startups in AI technology to a halt, as new entrants would have to bear the high costs of regulatory compliance and wrestle with regulatory constraints on new designs.[1]

Futurist Michael Spencer notes in his article on Forbes: Artificial Intelligence regulation may be impossible to achieve without better AI, ironically. As humans, we have to admit we no longer have the capability of regulating a world of machines, algorithms and advancements that might lead to surprising technologies with their own economic, social and humanitarian risks beyond the scope of international law, government oversight, corporate responsibility and consumer awareness.[2]

The CFA Institute’s Centre for Financial Market Integrity, while referring to proponents of self-regulation, observed: “This group notes the efficiency of allowing the participants, who are the industry experts, to craft rules that more realistically reflect the issues of the industry, thereby reducing the regulatory burden on market participants. Given the speed with which the global markets move, supporters of self-regulation also cite the benefits of a system whose flexibility allows it to respond to market developments quickly, fostering innovation. They also note the advantages of a system that is basically self-funding, relieving the government of a financial burden.”[3]

Therefore, the SEBI should be circumspect while introducing reporting requirements for Financial Institutions in areas like Artificial Intelligence/ Machine Learning. While there are a few benefits of such a mechanism, growth and innovation in a fledgling sector like AI/ML must not be disincentivized by any means. That being said, building “an in-depth understanding and ensur(ing) preparedness for AI/ML policies in the future” is a constructive step. 

Author: Mr. Anant Joshi, Associate – Corporate & Commercial Law Practice at Khurana & Khurana, Advocates and IP Attorneys. In case of any queries please contact/write back to us at anant@khuranaandkhurana.com.

References:

[1] [1] https://www.sebi.gov.in/legal/circulars/may-2019/reporting-for-artificial-intelligence-ai-and-machine-learning-ml-applications-and-systems-offered-and-used-by-mutual-funds_42932.html.

[2] https://www.investopedia.com/terms/b/blackbox.asp.

[3] https://www.globenewswire.com/news-release/2018/06/18/1525672/0/en/Global-Algorithmic-Trading-Market-2018-2022-with-Citadel-Optiver-Tower-Research-Capital-Two-Sigma-Investments-Virtu-Financial-Dominating.html.

[4] DIRECTIVE 2014/65/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 15 May 2014.https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:02014L0065-20160701&from=EN

[5]https://www.federalreserve.gov/newsevents/speech/brainard20181113a.htm

[6] Lael Brainard, “Where Do Banks Fit in the Fintech Stack?” (speech at the Northwestern Kellogg Public-Private Interface Conference, April 28, 2017).

The Companies Act (Amendment) Ordinance 2019 Highlights and Analysis

INTRODUCTION

A Committee under the chairmanship of Mr. Injeti Srinivas formed by the Ministry of the Company Affairs (“MCA”) gave their recommendations to relook the offences under the Companies Act, 2013 (“Act”). Consequently ,The Ministry of Law and Justice had came out with an Ordinance dated 2nd November, 2018, further amending 31 provisions of the Act. Ordinance will cease to operate on 21st January, 2019. Since the Bill to make amendments to the Companies Act, 2013, is pending in the Rajya Sabha, the ordinance has been re-promulgated.Hence,the Government of India has re-promulgated an ordinance to amend the companies law to further improve the ease of doing business as well as ensure better compliance levels.

Overall 29 sections are amended and 2 new sections have been added through the previous ordinances, which were promulgated on 2nd November, 2018 (Ordinance 9 of 2018) and on 12th January, 2019 (Ordinance 3 of 2019).

SOME OF THE MAJOR AMENDMENTS AND IMPACT ON THE CORPORATE SECTOR

• In Section 2(41) of the Companies Act, the application for approving a change in financial year which was earlier to be made to “Tribunal”, now will be made to the “Central Government”.
• Commencement of Business -The Ordinance will put restriction on every company (incorporated post commencement of the Ordinance), to not to commence its business or exercise borrowing powers unless the directors file a declaration within a period of 180 days from the date of incorporation to the effect that every subscriber to the memorandum has paid the cost of the shares and the registered office is confirmed by filing required returns with the Registrar. Noncompliance, may be an extra ground for Registrar to strike off of the name of the company.
• Physical Verification- Registrar of Companies is now empowered vide a sub- section (9) to physically verify of the registered office on reasonable cause to believe that whether a business or operations is being carried out by the company. In case of any non- compliance of sub- section (1) in respect of having such an office in place is found, the same may also be an additional ground for Registrar to strike off of the name of the company.
• Alteration of Articles- The application for Alteration of the Articles to give effect to conversion of a public company to a private company which was earlier made to the Tribunal, now needs to be sent the Central Government.
• The creation of charges has to be registered within 30 days of creation which, on an application, may be extended by the Registrar to additional 30 days (existing provisions provided 270 days on payment of additional fee). In case of failure to register within the additional time of 30 days, the Registrar may, on an application, allow an additional period of 60 days from the date of application for which an ad valorem fee shall be levied.
• Punishment of contravention -Apart from the existing penal provisions on any contravention of the provisions of the chapter, any wilful furnishing of false or incorrect information or knowingly suppression of any material information pertaining to registration of charges shall tantamount to be a fraud and shall attract action under Section 447.
• Company or the person aggrieved by the order of the Tribunal may make an application to the Tribunal for relaxation or lifting of the restrictions placed under sub-section 8, within 1 year.
• Disqualifications of director –A new clause has been inserted under the Section linking Section 165, which shall be a ground for disqualification of a director, if he/ she breaches the limits of maximum directorship allowed there under. It is pertinent to note that falling under any of the clauses of Section 164 leads to automatic vacation of office that too, from all the existing companies. This is one of the significant provisions which need immediate attention.
• The Ordinance has increased the limit of offence for compounding before the Regional Director from 5 Lakhs to 25 Lakhs.
• The Power of the Adjudicating Authority has been expanded and the existing section empowered the adjudicating officer to impose penalty, by an order, on the company and the officer who is in default in case of any non- compliance or default of the provisions of the Act, however, such an order may henceforth be included any other person too, Further, the order of the adjudicating officer may also provide for rectification of the default by the concerned person. The penal provisions as provided in sub- section (8) shall apply to violation in compliance of the said order also.
• Penalty for repeated default-This newly inserted section provides for penalty of twice the amount of penalty in case of repeated defaults(repeated within 3 years from the date of order imposing penalty for earlier default) by companies or any person who had already been subjected to penalty under the Act.

CHANGES IN THE PENAL PROVISIONS

The changes that have been brought in the penal provisions have been consolidated in the following table for ready reference:

As per the Current ordinance the following 16 out of 81 Compoundable Offences shall now be liable to penalty instead of being punishable with imprisonment.

Author: Mr. Shubham Borkar, Senior Associate – Litigation and Business Development  and Lakshay Kewalramani –Intern, at Khurana & Khurana, Advocates and IP Attorneys. In case of any queries please contact/write back to us at shubham@khuranaandkhurana.com or at www.linkedin.com/in/shubhamborkar.