On June 13, 2022, the Securities and Exchange Commission charged three Charles Schwab investment adviser subsidiaries—Charles Schwab & Co., Inc.; Charles Schwab Investment Advisory, Inc. (“CSIA”); and Schwab Wealth Investment Advisory, Inc. (“SWIA,” and together with Charles Schwab & Co., Inc. and CSIA, “Charles Schwab”)—with violations of the Investment Advisers Act of 1940 for alleged misconduct associated with its robo-advisor, Schwab Intelligent Portfolios (“SIP”). Unlike most other robo-advisers, Charles Schwab did not charge an advisory fee for the SIP service. However, Charles Schwab required its SIP clients to hold pre-set amounts of cash—rather than investing in equities under market conditions where equities were outperforming cash—that was then loaned out by Charles Schwab Bank at higher interest rates than it paid to the SIP clients, resulting in a profitable spread for Charles Schwab and the equivalent of a hidden fee for its clients, since holding cash lowered their returns. Charles Schwab was ordered to pay almost $46 million in disgorgement, more than $5 million in prejudgment interest, and $135 million as a civil penalty. The $187 million in total sanctions will be returned to investors. Charles Schwab also agreed to an independent consultant to conduct a “comprehensive review” of its compliance policies, and agreed to provide ongoing cooperation to the SEC in an unusual provision—a sign that there may be additional charges yet to come.
Schwab Intelligent Portfolios and Cash Allocations
According to the allegations in the SEC’s order, which Charles Schwab neither admitted nor denied, Charles Schwab’s SIP robo-adviser provides automated, software-based investment portfolio management to clients. Most other robo-advisers charge advisory fees to their clients but SIP was unique in that it charged no fee. SIP made money for Charles Schwab by, instead, allocating a fixed percentage of their clients’ portfolios to cash and depositing that cash with Charles Schwab Bank, an affiliated bank. Charles Schwab management allegedly decided that, in order to avoid charging an advisory fee, an average of 12.5% of the SIP portfolio assets would be held in cash. This resulted in the most aggressive SIP portfolio containing 6% cash and the most conservative containing 29.4%. The SEC alleged that using these pre-set allocations allowed Charles Schwab Bank to make a minimum pre-set amount of revenue by loaning the cash out at higher interest rates than it paid to its SIP clients, profiting from the spread.
Charles Schwab was aware that these pre-set cash allocations reduced the SIP portfolios’ returns under market conditions where other assets such as equities outperform cash. In fact, the SEC alleged that Charles Schwab’s cash allocations resulted in lowering SIP investors’ returns by approximately the same amount as an advisory fee would have. Meanwhile, between March 2015 and November 2018, Charles Schwab had profited by almost $46 million from the spread on the SIP cash allocations.
Form ADV Filings and Advertising
SWIA’s and CSIA’s ADV brochures contained misleading statements regarding the cash allocations for the SIP portfolios:
- First, the brochures stated that the cash allocations were “set based on a disciplined portfolio construction methodology designed to balance performance with risk management appropriate for a client’s goal, investing time frame, and personal risk tolerance.” The SEC contended this was not true as the cash allocations were pre-set based on reaching minimum revenue targets for Charles Schwab Bank, and not with portfolio performance in mind. Indeed, the SEC alleged that portfolio construction methodologies were applied only after the cash allocations, with the allocations acting as a constraint on portfolio construction.
- Second, the brochures stated that “[t]he cash allocation can affect both the risk profile and the performance of a portfolio.” The SEC contended this was misleading because Charles Schwab’s own analyses showed that in market conditions where other assets such as equities outperformed cash, the cash allocations would in fact lower the SIP portfolios’ returns.
- Third, SWIA’s brochure stated that “The higher the [cash] Allocation and the lower the interest rate paid the more Schwab Bank earns, thereby creating a potential conflict of interest . . . . To mitigate any potential conflict . . . the Program strategies [are constructed] pursuant to modern portfolio theory, which seeks to construct an optimal return goal for a portfolio based on the level of risk an investor is willing to take.” CSIA’s brochure had a similar statement. The SEC charged that these statements were misleading because (1) the conflict of interest was actual, not potential, and (2) the pre-set cash allocations did not allow for returns to be maximized.
Initially, before SIP launched, SWIA’s ADV brochure disclosed that SIP’s cash allocations were higher than other services because SIP clients did not pay an advisory fee, that there was a conflict of interest in setting the cash allocations, and that the conflict of interest would result in higher cash allocations, which could negatively impact performance in a rising market. But SWIA changed its disclosures following several criticisms of SIP in the press in late February 2015, removing details regarding its conflict of interest.
Finally, the SEC alleged that after SIP launched, Charles Schwab & Co., Inc. published advertisements with misleading statements, including one that said that SIP had “no hidden fees [and] no advisory fees.”
The SEC found that SWIA and CSIA violated Section 206(2) of the Advisers Act, which makes it unlawful for an adviser, directly or indirectly, to engage in any transaction, practice, or course of business that operates as a fraud or deceit upon any client or prospective client.
The SEC also found that Charles Schwab violated Section 206(4) of the Advisers Act, which prohibits any investment adviser from engaging in “any act, practice, or course of business which is fraudulent, deceptive, or manipulative,” and that it violated related advertising rules and failed to implement adequate compliance policies and procedures.
Disgorgement, Penalties, and Undertakings
Charles Schwab was ordered to pay disgorgement to harmed investors of $45,907,541, prejudgment interest of $5,629,320, and a civil penalty of $135 million. The money will be returned to investors through a fund administered by Charles Schwab.
Charles Schwab also agreed to retain an independent compliance consultant to “conduct a comprehensive review” of its compliance policies and procedures to ensure that Charles Schwab’s disclosures, advertising, and marketing communications to clients about SIP comply with federal law. Charles Schwab will be required to adopt the consultant’s recommendations.
- Robo-advisers have been increasing in usage in the investment advisory space in recent years. The Charles Schwab case indicates that robo-advisers are on the SEC’s radar and that the SEC will aggressively pursue disclosure and compliance cases against these advisers.
- All investment advisers should be on notice that the SEC will scrutinize their practices—whether automated or otherwise—for features that could be characterized as “hidden” costs or fees. Charles Schwab’s “no fee” robo-adviser was a selling point, but the “no fee” claim and the non-standard level of cash allocation also made Charles Schwab a target for scrutiny.
- Notably, the SEC did not allege that Charles Schwab’s cash allocations were wrongful. Instead, the issue was the disclosures related to the cash allocation. The case serves as a reminder to ensure that disclosure language matches the reality of the features being described.
- The SEC’s order contained a provision requiring Charles Schwab to provide “ongoing cooperation” to any SEC investigations or litigation related to the case, and to maintain “in strict confidence” any communications with the SEC staff. This is not a standard provision in SEC settlements, and is instead used when the SEC staff envision charging and potentially litigating against additional defendants. Accordingly, the settlement with Charles Schwab may not be the last enforcement action to result from SIP.
- The independent compliance consultant Charles Schwab agreed to as part of the settlement will likely prove to be costly and potentially intrusive. Investment advisers hoping to avoid a similar outcome should take note and revisit their own disclosures.
 An ADV brochure is the primary disclosure statement for investment advisers wherein they disclose their business practices, fees, conflicts of interest, and disciplinary information.