State and local issuers engaging in the offer and sale of municipal securities must comply with the antifraud provisions of federal securities laws, namely Section 17(a) of the Securities Act of 1933 and Rule 10b-5 of the Securities and Exchange Commission. In that context, it is unlawful for such issuers to make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements that are being made not misleading.
Any statements that can be reasonably expected to reach the investing public, including disclosures from offering documents, investor presentations, press releases, or websites, would be subject to SEC scrutiny under these antifraud provisions.
Recently, the SEC has focused its attention on disclosures related to
AI-washing occurs when entities embellish, overstate, exaggerate, or otherwise make unrealistic claims about their use of AI, to attract investors looking for AI-driven investment opportunities. Thus far in 2024, the SEC has investigated two investment advisors and one former CEO of a public company for allegedly making false or misleading statements regarding the beneficial uses of AI in their respective businesses.
The SEC's recent scrutiny notwithstanding, in an effort to capitalize on AI's growing popularity, state and local issuers are increasingly disclosing the beneficial impact of AI technologies (regarding their operations, projects, emerging industries or other enterprises) in their offering documents and other public statements.
Additionally, issuers may find AI to be a useful tool in transitioning their financial reporting to the new machine-readable, structured data format required by the Financial Data Transparency Act (with a likely effective date in 2027). Given this trend, such issuers (and their counsel and other public finance professionals) should act now to mitigate the risks of AI-washing, as disclosure practices evolve to address this new technological reality.
By way of background, to attract environmentally conscious investors, issuers of municipal securities frequently incorporate environmental, sustainability or other climate-related disclosures into their offering documents.
Typically, these disclosures describe projects or other initiatives designed to combat extreme weather events and the effects of climate change, or provide other environmental benefits, considering each issuer's particular facts and circumstances.
Recognizing this movement, the SEC has warned issuers of the risks associated with "greenwashing." Like AI-washing, greenwashing occurs when issuers make false or misleading claims about their environmental awareness, or the environmentally friendly nature of projects, services, or industries.
As with greenwashing, AI-related disclosures may expose issuers to AI-washing risk due to the lack of defined AI disclosure standards and/or the marketing of AI claims without sufficient backup data.
Luckily, the same safety tips for avoiding greenwashing also apply to AI-washing.
Specifically, in approaching offering documents and other public statements, issuers should: verify the accuracy of AI-related statements regarding the issuer and/or project; substantiate such claims with objective data and analysis; use precise language, avoiding broadly worded AI-related buzzwords or catchphrases that could be misinterpreted by investors; ensure that all publicly available statements regarding the issuer and/or project are consistent in their AI-related claims; disclose the particular risks and opportunities of AI relative to the issuer and/or project, in contrast to using boilerplate or "one size fits all" language; and review the claims made regarding AI regularly with their counsel and other public finance professionals, updating the disclosure as needed for accuracy.
Notwithstanding the foregoing, two recent U.S. Supreme Court decisions have the potential to reshape the SEC's approach to securities fraud cases, including those related to AI-washing.
First, in SEC v. Jarkesy, the Supreme Court held that a defendant has the right to a jury trial in cases where the SEC seeks civil penalties for alleged securities fraud. As a result, the SEC must adjudicate such matters in federal court, rather than through the SEC's administrative tribunal system.
Second, in Loper Bright Enterprises v. Raimondo, the Supreme Court overturned the so-called Chevron deference doctrine, where a reviewing court previously deferred to a federal agency's interpretation of an ambiguous statute.
Instead, the reviewing court must exercise its independent judgment in determining whether a federal agency has acted within its statutory authority, including situations involving ambiguous statutes.
Given the significance of these decisions, the SEC and other federal agencies may rethink certain legal strategies in the future. Practically speaking, however, the immediate impact of these decisions on the SEC's enforcement activities, under the antifraud provisions or otherwise, currently remains an open question.
Theoretically, by deploying the latest technological advancements in AI, state and local issuers will achieve greater efficiencies in operations, services and infrastructure.
It is therefore understandable that such issuers would like to promote such accomplishments in their offering documents and other public statements. However, in making such disclosures, issuers should be careful not to fall into the trap of AI-washing by overpromising and underdelivering on such achievements, particularly given the rapidly evolving nature of the technology.
Rather, issuers should work closely with their counsel and other public finance professionals on the topic of AI, to ensure that any public statements involving such emerging technologies remain accurate, complete and in compliance with the federal securities laws.
