United States: Model Risk Strikes Again: SEC Imposes $3 Million Fine Due To Error In Computer Model

On April 19, 2019, the US Securities and Exchange Commission (SEC) published a settled administrative proceeding against Prosper Funding LLC (Prosper) for violating Section 17(a)(2) of the Securities Act of 1933 (Securities Act) based on an error in a quantitative model that generated inaccurate performance data.1 The SEC imposed a $3 million fine on Prosper as a result of the error.

That the SEC expects registrants to properly maintain and control quantitative models has been highlighted in prior settlements with the SEC.2 A central theme in the Prosper settlement, though, is the SEC's focus on the fact that Prosper's own personnel conceded in multiple instances that they did not understand how the code at issue operated. Although not expressly stated, the order suggests that errors arising due to lack of understanding of model functioning will likely be sufficient for the SEC to assert the negligent conduct necessary to support a claim under Section 17(a)(2).

This highlights a central risk for many registrants: Registrants who are using code that is dated (e.g., based on legacy code language no longer used by today's coders) or who use code with limited documentation and where staff turnover has led to limited familiarity with their own code are at risk of Securities Act (and possibly other) claims in the event of even inadvertent errors in their code. Furthermore, although not specifically addressed in the Prosper order, registrants who rely on newer models (such as those based on artificial intelligence, natural language processing or similar tools) and are unable to understand or explain the operation of those tools may similarly be at risk in the event that such tools generate erroneous data or results.

Registrants should take care to inventory their quantitative models; to maintain effective change controls, testing and validation protocols; and to ensure proper governance over those models.  But they should also periodically audit the performance of outputs from all models and make sure that users understand how the models generate those outputs. Such steps should be built into a registrant's model governance process. By employing effective model governance oversight, registrants may not only avoid such costly errors in the future but also strengthen their defenses in the event of such errors by demonstrating that their control systems and oversight were not negligent.

Summary of Facts

Prosper is a privately held3 marketplace lender that arranges consumer loans through its website and sells securities linked to the performance of those consumer loans to investors (Prosper securities). Prosper provided each investor with information on the consumer loans and the performance of the investor's Prosper securities, including prominently reporting each investor's annualized net returns (ANR). Prosper calculated ANR through an automated process in its computer code.

2009 Secondary Market Activity – In 2009, Prosper's parent company began offering investors access to a secondary market for these securities. At that time, Prosper changed the method for calculating ANR to exclude securities sold in the secondary market.

2015 Debt Sale Program – In July 2015, Prosper implemented a "debt sale program" through which eligible non-performing, charged-off consumer loans linked to Prosper securities were sold to third parties. Although this program was unrelated to the secondary market for Prosper securities, Prosper's coding incorrectly treated the securities linked to these charged-off loans as securities sold in the secondary market and thus excluded the performance of those securities from the ANR calculation provided to customers. As a result, for investors whose securities were linked to loans sold through the debt sale program, Prosper reported an ANR that excluded the impact of the worst performing securities that they had previously held.

Coding Reviews – In late 2014, after an engineering review, Prosper determined that it should rewrite its older "legacy" code. Importantly, Prosper learned that its current employees did not fully understand the operation of the older, legacy code. At that time, Prosper focused on rewriting the legacy code for the borrower-facing platform, but this did not include the ANR code. According to the SEC, Prosper did not take any steps to monitor operation of the ANR code to ensure it was correctly calculating ANR. In late 2015, Prosper undertook a "code inventory" of the ANR code for possible use in a different project. Through this process, Prosper again identified the fact that its current employees lacked understanding of the code's operation. But Prosper did not identify the error in the ANR calculation.

Impact – Because of Prosper's error in the ANR calculation, Prosper told more than 30,000 of its investors (the majority of its investors) that their Prosper investments were performing better than they actually were (in some cases, double the returns actually earned). Prosper also solicited new investments in Prosper securities based on the miscalculated ANR. Specifically, it sent emails to tens of thousands of investors highlighting the erroneous ANR, recommending that they "[a]dd funds and build on [their] solid returns." Tens of thousands of the affected investors made additional investments in Prosper securities. For many of them, their decisions were based in part on the inaccurate ANR.

Discovery and Disclosure – Prosper did not identify the error for almost two years and discovered it only after receiving a complaint from a large institutional investor in April 2017. On May 3, 2017, Prosper notified investors that it had miscalculated and misstated their ANR and provided a current, correct calculation of ANR to investors.

Remedial Actions – Sincediscovery of the error, Prosper instituted certain controls designed to prevent and detect similar errors in the future, including management supervision of the ANR calculation and data owners, quarterly reviews of any changes that could have an impact on the data used in the ANR calculation and semi-annual testing of the ANR calculation.

Observations and Lessons Learned

To support a claim under Section 17(a)(2), the SEC must demonstrate that any misstatement of material fact was, at the least, the result of negligent behavior on the part of the registrant. In connection with that standard, the order goes to significant lengths to highlight that Prosper did not understand the operation of its own code. The order states that "Prosper failed to identify and correct the error despite its employees' knowledge that Prosper no longer understood how the code underlying the ANR calculation operated, and despite investor complaints about possible errors in their reported ANR." The order specifically noted that in 2014, when Prosper determined the need to update its older "legacy" code, Prosper learned "that its current employees did not fully understand the operation of the older, legacy code." It noted that "Prosper did not take any steps to monitor operation of the ANR code to ensure it was correctly calculating ANR." The order further noted that in 2015, when Prosper undertook a "code inventory of the code for calculating ANR for possible use in a different project," Prosper "again identified the fact that its current employees lacked understanding of the code's operation."

Many registrants likely use older, legacy code in business operations (whether in the calculation of returns or otherwise). Furthermore, such code is often being updated or modified, and the individuals who coded the original tool may no longer be employed at the company. Moreover, where software has been licensed or acquired from a third party, the registrant's existing employees may have limited understanding of the functioning of that code. Registrants should ensure that proper documentation explaining the code functioning is generated for future use by the company, and its governance model should address code development and life cycle processes to ensure that people at the company understand and can competently use, and test for fitness for purpose, the models employed by the company.

The order is also a shot across the bow of registrants who are beginning to deploy models premised on artificial intelligence or machine learning tools, where models may be opaque or may generate results that the registrant does not fully understand or, worse, did not intend. The SEC appears to be laying a foundation for a position that the failure to understand models employed by registrants may alone be sufficiently negligent that any resulting misstatement will be deemed negligent. Consequently, registrants should document the operations of, set in place proper monitoring and governance of, and be prepared to explain the operation of such tools if necessary.

Footnotes

1 The SEC order did not raise any investment adviser, investment company or broker-dealer status issues.

2 Much regulatory focus has been placed on the use of models, algorithms and the like in the investment management arena. However, this order highlights the fact that any type of business entity that uses or otherwise relies on models, algorithms or other automated processes should be cognizant of, and try to mitigate, the associated risks.

3 Prosper and its parent, Prosper Marketplace, Inc. (parent), have publicly issued debt securities for a number of years.

Visit us at mayerbrown.com

Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the "Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP and Mayer Brown Europe – Brussels LLP, both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales (authorized and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC 303359); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong Kong partnership and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

© Copyright 2019. The Mayer Brown Practices. All rights reserved.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions