Schwab’s Robo SEC Settlement Highlights Disclosure Pitfalls

In addition to a monetary settlement, three Charles Schwab investment adviser subsidiaries have agreed to retain an independent consultant to review their policies and procedures relating to their robo-adviser’s disclosures, advertising and marketing practices.

By DJ Shaw

The Securities and Exchange Commission announced this week that it has charged three Charles Schwab investment adviser subsidiaries for not disclosing that they were allocating client funds in a manner that their own internal analyses showed would be less profitable for their clients under most market conditions, according to a press release from the regulator.

Without admitting or denying the SEC’s findings, the investment adviser subsidiaries—Charles Schwab & Co. Inc., Charles Schwab Investment Advisory Inc. and Schwab Wealth Investment Advisory Inc.—agreed to a cease-and-desist order prohibiting them from violating the antifraud provisions of the Investment Advisers Act of 1940. The order also censures the firms and requires them to pay approximately $52 million in disgorgement and prejudgment interest, alongside a $135 million civil penalty.

The subsidiaries also agreed to retain an independent consultant to review their policies and procedures relating to their robo-adviser’s disclosures, advertising and marketing, and to ensure that they are effectively following those policies and procedures.

According to the SEC, from March 2015 through November 2018, Schwab’s mandated disclosures for its robo-adviser product, “Schwab Intelligent Portfolios,” stated that the amount of cash in the robo-adviser portfolios was determined through a “disciplined portfolio construction methodology,” and that the robo-adviser would seek “optimal return[s].”

In reality, the press release says, the SEC found that Schwab’s own data showed that under most market conditions, the cash in the portfolios would cause clients to make less money, all while taking on the same amount of risk. Schwab advertised the robo-adviser as having neither advisory nor hidden fees, says the release, but it didn’t tell clients about this “cash drag” on their investment.

Schwab made money from the cash allocations in the robo-adviser portfolios by moving the cash to its affiliate bank, loaning it out and then keeping the difference between the interest it earned on the loans and what it paid in interest to the robo-adviser clients, the release says.

Separately, the SEC voted in early 2020 to significantly revamp its advertising and communications standards for registered firms. The finalized amendments created a single rule to replace the previously distinct advertising and cash solicitation rules. According to the SEC’s leadership, the final rule is designed to more “comprehensively and efficiently” regulate investment advisers’ marketing communications. They say the reforms will allow advisers to provide investors with useful information as they choose investment advisers and advisory services, subject to conditions that are reasonably designed to prevent fraud. The new framework takes full effect in November, and experts expect firms will embrace the new rules.