California is close to putting generative AI obligations for lawyers into a statute. Senate Bill 574 (SB 574), authored by Senator Thomas Umberg, would add explicit duties for attorneys who use generative AI in the practice of law and would restrict certain uses of AI by arbitrators.[1]
SB 574 has already passed the California Senate unanimously (39–0) and is now in the Assembly, where it has been read for the first time and is currently held at desk.
The bill does not try to stop lawyers from using AI. Instead, it makes the lawyer (and, in arbitration, the arbitrator) legally responsible for managing predictable risks such as confidentiality leakage, fabricated citations, and biased or discriminatory outputs.
Why the Legislature Thinks This Is Necessary
Generative AI is already being used for legal research, drafting, summarizing records, and client communications. The efficiency gains are real, but so are the risks. AI can produce confident but false answers, invent citations, and recycle or expose sensitive information depending on how it is used.
California courts have already dealt with AI-driven filing errors. In a published decision, Noland v. Land of the Free, L.P., the Court of Appeal sanctioned counsel after a brief included fabricated quotations and other AI-generated errors, emphasizing that lawyers must personally read and verify what they cite. [2]
Until now, the core guardrails have come from professional responsibility principles and State Bar guidance.[3] SB 574 would move key expectations from “best practice” into “black letter” law.
SB 574 would add Business & Professions Code section 6068.1 and impose four practical obligations on any attorney using generative AI in the practice of law:
1. Keep Confidential and Nonpublic Data Out of Public AI Systems
An attorney would have to ensure that confidential, personally identifying, or other nonpublic information is not entered into a public generative AI system. In plain English: do not paste client facts, documents, or identifiers into consumer tools unless you have clear protections on retention, training, access controls, and confidentiality. Most of the paid subscriptions to ChatGPT, for example, provide a “private” space and promises the input, and output, will not be used outside of that closed environment or to train its AI models. The free versions of ChatGPT, however, do not offer this kind of privacy and client protection environment. With AI, you get what you pay for.
2. Avoid Unlawful Discrimination and Disparate Impact
An attorney would have to ensure the use of AI does not unlawfully discriminate or disparately impact individuals or communities based on protected characteristics. If AI is used to sort, screen, prioritize, or recommend actions, bias risk becomes an express compliance issue.
3. Take Reasonable Steps to Verify Accuracy and Remove Harmful Content
An attorney would have to take reasonable steps to verify accuracy, correct hallucinated or erroneous output, and remove biased, offensive, or harmful content in AI material used. The output is not the end of the job; it is the start of the review.
4.Consider Disclosure When AI-Generated Content Is Provided to the Public
The bill would not mandate disclosure across the board, but it would require lawyers to consider whether disclosure is appropriate when AI is used to create content provided to the public (for example, marketing, public-facing advisories, or other broad communications). Our firm, as an example, updated our standard client retention agreements to specify how and when we use AI and we assure our clients it not only makes our attorneys and staff more productive, but we do not charge for the actual use of AI. We also clearly disclose our AI policy on our website.
The Sharpest Edge: Filings and Citations
SB 574 would also amend Code of Civil Procedure section 128.7 (California’s sanctions statute for improper filings). It would add an explicit requirement: no brief, pleading, motion, or other paper filed in court may contain citations the attorney has not personally read and verified, including citations generated by AI.
This is the provision that will change behavior fastest. It turns what many judges already expect into a statutory bright line: if it is cited to the court, the lawyer is on the hook for it.
AI and Arbitration: No Outsourcing the Decision
SB 574 would add Code of Civil Procedure section 1282.1, regulating arbitrators’ use of generative AI. The theme is straightforward: AI may not become a silent decision-maker.
An arbitrator could not delegate any part of the decision-making process to generative AI, and AI could not replace the arbitrator’s independent analysis of facts, law, and evidence.
If an arbitrator intends to use AI-generated information outside the record, the arbitrator would have to disclose it in advance and, as far as practical, give the parties an opportunity to comment.
If an AI tool cannot cite independently verifiable sources, the arbitrator may not assume those sources exist or that the AI’s characterization is accurate; the arbitrator remains responsible for the award.
If enacted, SB 574 will push firms toward clearer policies and better documentation of AI workflows. Three near-term implications are worth highlighting:
1. Tool Selection Becomes a Professional Responsibility Issue
Lawyers will need to distinguish between public consumer tools and systems with enterprise-grade confidentiality and retention controls. “We didn’t know how the tool handled data” will not be a good answer. Attorneys must know and must ensure client data is not disseminated outside of a secure work area.
2. Verification Becomes a Defined Step in the Work Product Pipeline
Firms should expect to implement checklists and supervision rules, citation pulls, record checks, and required human review before anything goes to a client or court.
3. Litigation Risk Increases When AI Is Used Casually
A single hallucinated authority can now lead more directly to sanctions exposure, reputational damage, and malpractice claims. AI can speed up drafting, but it can also accelerate mistakes.
What Clients Should Ask and Why It Matters
Clients should not need to fear AI, but they should care how it is used. A few direct questions can prevent misunderstandings and reduce risk:
Are you using generative AI on my matter, and if so, for what tasks?
What protections prevent my confidential information from being entered into a public AI system?
What is the human review process before AI-assisted work product is delivered or filed?
How do you handle billing when AI increases speed, especially in hourly matters?
For some matters, clients may also want to address AI use explicitly in engagement letters or outside counsel guidelines, especially around confidentiality, acceptable tools, and retention of matter data.
As of March 24, 2026, SB 574 has cleared the Senate unanimously and has moved to the Assembly. It has been read for the first time in the Assembly and is currently held at desk. Next steps are committee referrals and hearings, followed by an Assembly floor vote. If amended, the bill would typically return to the Senate for concurrence before going to the Governor.
SB 574 would make one point unavoidable: lawyers can use AI, but they cannot outsource judgment. If it passes, California will have a clear statutory framework that forces responsible AI use in the practice of law and gives courts and clients a cleaner yardstick to measure it.
Shustak Reynolds & Partners, P.C. focuses its practice on securities and financial services law and complex business disputes. We represent many investment advisors, financial professionals, broker-dealers, registered representatives, investors and businesses. Attorney Erwin J. Shustak can be reached in the firm’s San Diego office at (619) 696-9500.
FINRA and the SEC have proposed replacing FINRA Rules 3270[1] and 3280[2] with a single new Rule 3290[3] designed to narrow reporting to investment-related activities and preserve stricter controls for outside securities transactions, especially when selling compensation is involved. This proposed regulation is currently before the SEC and may be adopted this spring.[4]
1. The Proposal Would Narrow The Existing, Broad, “Outside Business Activity” Rule to Require Reporting Only of “Investment-Related” Outside Activity
Currently, Rule 3270 broadly prohibits a registered person from engaging in virtually any outside business activity without notice to their FINRA member firm. Once the member receives the notice, it must evaluate whether to place conditions on the activity and determine if the activity falls under Rule 3280. If it does, Rule 3280 then prohibits certain outside securities transactions by an associated person (whether registered or not) without the member’s approval and supervision.
This reporting, approval and supervision process can be extensive and covers a very wide variety of activities that are not plausibly related to the securities business. The proposed Rule 3290 would consolidate these two existing rules into one, while maintaining the basic substantive framework regulating Outside Activities for registered persons and Outside Securities Transactions for associated persons.
The major change proposed is to narrow the scope of outside business activity reporting. The term “Outside Business Activity” is gone from the proposed rule. It is replaced with the phrase “outside activity” which is given the more specific and narrow definition of “investment-related activity outside the scope of such person’s relationship with the member that is not in connection with a securities transaction.” [5] This focus on investment-related outside activity would mean that member firms will no longer have to process large volumes of low-risk, non-investment side work, such as bartending or driving for a car service.
While the class of outside activities covered is narrowed by the proposed rule, the obligations of the registered persons and firms in reporting the activities still covered would remain very similar to the old regime. A registered person would still have to provide prior written notice to the member. The member firm would still assess whether the activity is properly characterized, whether it involves customers, whether it could interfere with the person’s responsibilities, and whether customers or the public might view the activity as part of the firm’s business. The proposal also adds a small provision requiring the member to consider whether the outside activity involves customers, but that seems more a clarification of the intent of the prior regime than a substantive addition.
For outside securities transactions, the proposed requirements remain largely the same. Even the few changes clarify requirements and restate prior guidance rather than make any major substantive adjustments. An associated person still has to provide prior written notice to the member, and the member still has to evaluate the transaction, decide whether to prohibit or approve the rule, or approve with conditions, and then to supervise and record the transaction as though executed on the firm’s behalf.
2. Member Firms and Advisers Supported the Proposal, While Some Investor Advocates Prefer a More Limited Reform
Public comments at the SEC closed on February 24, 2026, and they reflected the same support and opposition that were seen in the public comments to FINRA a year earlier. They reflect a clear divide by commenter type, with members and advisers supporting the change, and some investor advocates recommending broader coverage than that in the proposed rule.
Comments from broker-dealers and investment advisers generally support the proposal on the basis that the existing rule requires firms to review large amounts of irrelevant or low-risk information. They argue that by limiting the reporting obligation to investment-related activity, the rule would free compliance resources for conduct that is more likely to harm investors or blur the line between the representative’s personal venture and the member’s business.
Securities Industry and Financial Markets Association (SIFMA) supported proposed Rule 3290 as a modernization measure that improves efficiency without sacrificing investor protection.[6] LPL Financial took the same basic position. It argued that the current framework creates unnecessary burdens and that the proposal better aligns regulation with actual risk.[7]
The Investment Adviser Association also endorsed the rule and specifically supported excluding unaffiliated advisory activity from broker-dealer supervision and recordkeeping. It argued that advisory activity already falls under the Advisers Act or state regulation and that broker-dealer oversight in that setting is duplicative and impractical.[8]
Comments from individual advisers agreed. Cline Reasor of Gratus Wealth Advisors argued that the current rule forces dual registrants to share nonpublic advisory-client information with an unaffiliated broker-dealer and adds complexity without corresponding benefit.[9] Frank Lawrance of Seacrest Wealth Management likewise supported the proposal because it would reduce approval and reporting obligations for advisory activity that is already regulated elsewhere while retaining safeguards against selling away.[10]
Consumer organizations and some members of the plaintiff’s bar opposed the proposal or urged tighter supervision, arguing that the proposal gives too much weight to whether an activity is “investment-related” when misconduct often develops through mixed business lines and informal referrals. They suggested that an activity that looks non-securities-related at the outset can become a source of customer confusion, affinity solicitation, or undisclosed compensation. These commenters suggested that a narrower rule may leave firms with less visibility into emerging conflicts.
For example, Joseph Peiffer, a past president of the Public Investor Arbitration Bar Association, argued that the rule would weaken oversight of the very outside activities that often precede fraud, selling away, and customer confusion.[11] Peiffer also noted that excluding certain affiliate activity would rely too heavily on assumptions about effective cross-business controls.
The North American Securities Administrators Association, an investor protection organization, urged stronger emphasis on supervisory red flags and a framework that better reflects the risks that arise when customers encounter combined brokerage and advisory relationships. The NASAA proposed additional language that would still narrow the existing reporting requirements, but add additional categories of activities such as lending, or brokering collectibles that it felt would more effectively implement the purpose of the streamlined rule without creating unintended loopholes.[12]
3. The SEC Is Expected to Act Soon
After publication and comment at FINRA in 2025, FINRA finalized its recommendation by filing the proposal with the SEC on January 22, 2026, as SR-FINRA-2026-001. The SEC issued a notice of proposed rule change, and the proposal was published in the Federal Register on February 3, 2026.[13] The SEC set February 24, 2026 as the public-comment deadline. A final decision by the SEC to approve or disapprove the rule change is expected very soon.
Whether this or a similar rule is eventually adopted, it appears that a consensus has emerged to narrow the rule somewhat. Whether the SEC acts this spring or next year, it seems likely that some new rule will eventually be adopted limiting the OBA reporting rule to business activities that are more directly related to the financial industry.
Shustak Reynolds & Partners, P.C. focuses its practice on securities and financial services law and complex business disputes. We represent many investment advisors, financial professionals, broker-dealers, registered representatives, investors and businesses. Attorney William M. Moore can be reached in the firm’s San Diego office at (619) 696-9500.
The U.S. Department of Labor has issued a new Notice of Proposed Rulemaking addressing how to determine whether a worker is an employee or an independent contractor under the Fair Labor Standards Act.[1] The proposal would rescind the Department’s 2024 final rule and largely restore the framework adopted in 2021, with certain modifications.[2]
For the financial services industry, the central issue is whether this proposal preserves the viability of the long-standing independent broker-dealer model in which affiliated financial advisors are treated as independent contractors. The proposal does not create a special exemption for financial professionals. The structure of the new rule, however, and particularly its emphasis on control and opportunity for profit or loss, is generally consistent with the operational realities of many independent advisory practices, meaning most independent advisors likely would continue to be properly classified as independent contractors. At the same time, it places renewed emphasis on actual practice over contractual form, which will require firms and advisors to assess how independence functions in fact, rather than in theory.
I. Overview of the Proposed Rule
The proposal would replace the 2024 rule with a framework that centers on what the Department describes as the “economic reality” test.[3] The ultimate inquiry under that test is whether the worker is economically dependent on the potential employer for work, or instead is in business for himself or herself. Under the proposed framework, two factors typically carry greater weight than others:
1. The nature and degree of the individual’s control over the work. 2. The individual’s opportunity for profit or loss based on initiative or investment.[4]
The proposal also reiterates that the parties’ actual day-to-day practice is more relevant than contractual provisions that reserve rights which are not exercised in reality.[5]
The Department expressly criticizes the 2024 rule as overly complex and potentially restrictive of legitimate independent contractor relationships.[6] It proposes to streamline the analysis and to return to a structure that it believes better reflects Supreme Court precedent and decades of federal appellate decisions.
II. How the Proposal Differs from the 2024 Rule
The 2024 final rule, which took effect on March 11, 2024, adopted a six-factor totality-of-the-circumstances analysis without assigning predetermined weight to any factor.[7] The Department characterized that framework as consistent with longstanding judicial precedent and the statutory text of the FLSA.
The new proposal departs from that approach in two material respects. First, it restores emphasis on two “core” factors, control and opportunity for profit or loss, which it states are typically more probative of whether a worker is economically dependent.[4] While no factor is dispositive, the proposal suggests that when both core factors point in the same direction, that outcome is likely correct.
Second, the proposal narrows certain elements that the Department believes expanded the analysis beyond what Supreme Court precedent requires.[6] The Department contends that the 2024 rule’s articulation of some factors, including investments and permanence, could be viewed as making independent contractor classification more difficult than the law demands.
The practical effect is a shift away from an evenly weighted multi-factor test toward a framework in which entrepreneurial control and business risk receive greater emphasis.
III. Interplay Between the Rule and Firms’ Regulatory Obligations
Independent broker-dealer models continue to be central to the securities industry. These firms, just as traditional employee-based models, are highly regulated and have obligations that may exceed those of a traditional independent contractor relationship. FINRA Rule 3110, for example, requires member firms to maintain a supervisory system to ensure compliance with applicable securities laws and FINRA rules.[8] That supervisory obligation often includes review of communications, product oversight, outside business activity approval, recordkeeping, and surveillance.
A recurring question in classification disputes is whether regulatory supervision constitutes “control” indicative of employee status. The proposed rule’s renewed emphasis on the nature and degree of control invites careful analysis in this context. The proposal makes clear the relevant inquiry concerns control over the manner and means of the work as part of an economic relationship. Regulatory compliance measures that arise from statutory or self-regulatory requirements do not automatically establish an employment relationship. The focus remains on whether the advisor is operating an independent business or functioning as a worker dependent on the firm for work.
IV. Why Many Independent Advisor Models May Align with the Proposal
Many independent advisory practices exhibit characteristics that align with the proposal’s core factors.
A. Opportunity for Profit or Loss
First, under the proposal, meaningful opportunity for profit or loss based on initiative and investment is central.[4] Advisors who control marketing strategy, client acquisition, staffing decisions, office expenses, and growth planning often have genuine entrepreneurial upside and downside. Where income depends on production, client retention, and cost management, the advisor’s economic outcome is tied to business decisions rather than fixed compensation.
If an advisor can increase profitability through managerial skill and can incur losses through business expenditures, those facts tend to support independent contractor classification under the proposed framework.
B. Control Over the Business
Advisors who set their own schedules, choose office locations, hire and compensate staff, and manage client relationships typically exercise a degree of autonomy consistent with independent business ownership. The proposed rule directs attention to actual practice, not merely contractual recitations or constraints.[5]
Where firms limit their involvement to regulatory supervision and platform or back-office support, and do not dictate daily work methods, prospecting strategies, or operational management, the control factor may weigh in favor of independent contractor status.
C. Distinguishing Compliance from Employment Control
The existence of FINRA supervision does not eliminate independence.[8] Broker-dealers are required to supervise associated persons. The classification inquiry is whether that supervision extends into employer-like direction over the manner and means of performing the work. Firms that maintain clear boundaries between compliance oversight and business management will be better positioned under the proposed framework.
V. Areas of Heightened Risk
The proposal does not insulate the financial services industry from classification challenges. Several areas present risk.
1. Employer-Like Operational Control
If a firm dictates mandatory hours, assigns territories, prescribes specific marketing methods unrelated to compliance, or otherwise directs the day-to-day conduct of the advisory practice, the control factor may weigh toward employee status.
2. Limited Entrepreneurial Risk
If an advisor’s compensation resembles a wage and the advisor bears little real expense or downside risk, the profit-or-loss factor may weaken. The proposal’s emphasis on entrepreneurial opportunity requires that the opportunity be substantive, not theoretical.
3. Divergence Between Agreement and Reality
The proposal emphasizes that actual practice governs.[5] Firms that rely on carefully drafted independent contractor agreements but manage advisors in a centralized and prescriptive manner may face challenges.
4. Enforcement Volatility
In May 2025, the Wage and Hour Division issued Field Assistance Bulletin 2025-1, stating that it would not apply the 2024 rule’s analysis in investigations while the Department reconsidered that rule.[9] This development illustrates that classification standards may shift with changes in administrative policy. Financial institutions should assume that classification practices will be scrutinized under evolving interpretations.
VI. Practical Considerations for Broker-Dealers and Advisors
Given the proposal’s emphasis on control and entrepreneurial opportunity, firms and advisors should consider the following:
– Maintain documentation demonstrating that advisors bear real business expenses and exercise managerial discretion. – Clearly separate compliance supervision from directing the day-to-day operations of an independent advisor. – Align compensation structures with genuine business risk and reward. – Periodically review practices to confirm that independence is reflected in daily operations.
Firms that operate both employee and independent contractor channels should ensure that operational distinctions are meaningful and consistently applied. The presence of parallel structures heightens the importance of maintaining these distinctions.
Conclusion
The Department of Labor’s proposed rule represents a meaningful recalibration of the federal independent contractor framework. By restoring emphasis on control and opportunity for profit or loss, the proposal aligns more closely with traditional concepts of independent business ownership.
For independent financial advisors, the proposal does not undermine the viability of the independent broker-dealer model. Many advisory practices that function as genuine businesses should continue to support independent contractor classification under the proposed analysis. However, the rule reinforces that independence must be real. Where operational control resembles employment and entrepreneurial risk is minimal, the label of “independent contractor” will not always control the outcome if challenged.
Financial professionals, firms, and counsel should view the proposal as an opportunity to evaluate whether current business structures and procedures reflect the economic reality of true independence.
Shustak Reynolds & Partners, P.C. focuses its practice on securities and financial services law and complex business disputes. We represent many investment advisors, financial professionals, broker-dealers, registered representatives, investors and businesses. Attorney George C. Miller can be reached in the firm’s San Diego office at (619) 696-9500.
