The SEC started the week by announcing that Charles Schwab
In federal documents, three Schwab investment advisor subsidiaries are accused of not telling clients the truth about how their money was being allocated. Claims that the tech would rely on algorithms to optimize clients’ returns clashed with the reality that decisions were made based on what the company stood to gain.
SEC Division of Enforcement Director Gurbir S. Grewal called Schwab’s conduct “egregious” and stated that the fine sends “a clear message” about the importance of transparency. Meanwhile, without admitting or denying the allegations, Schwab officials said they
Both statements — released Monday within tight succession of one another — present statements of success, closure and optimism. But for veteran securities attorney Bill Singer, this case has no winners and potential impacts that could linger for every entity involved.
“If imposing disgorgement and civil penalties was an effective way of remediating these types of problems, one would infer that since the SEC keeps imposing fines on large brokerages, firms would stop what they're doing. Except they don't, so at the end of the day this really is nothing more than feel-good regulation from the SEC’s perspective,” Singer, who is not involved in the case, told Financial Planning. “And by and large, I tend to like how Schwab conducts business. What I don't like is lying to your customer. It’s like going to the Schwab butcher shop for several years and finding out that they've been putting their thumb on the scale.
“It could take a lifetime to build a reputation and just seconds to lose it. And once you lose it, you'll never get it back.”
According to the SEC’s order, Schwab’s mandated disclosures for Schwab Intelligent Portfolios, or SIP, from March 2015 through November 2018 stated that the amount of cash in robo-advisor portfolios was determined through a “disciplined portfolio construction methodology,” and that the robo-advisor would seek “optimal return[s].”
The order said that in reality, Schwab’s data showed that under most market conditions, the money allocated would cause clients to earn less while taking on the same amount of risk. The firm also advertised SIP as having neither advisory nor hidden fees, but did not disclose to clients this “cash drag” on their investments.
The SEC order said Schwab made money from the cash allocations by sweeping 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 SIP clients.
Schwab has agreed to pay approximately $52 million in disgorgement and prejudgment interest and a $135 million civil penalty. The subsidiaries also agreed to retain an independent consultant to review their robo-advisor’s disclosures, advertising and marketing to ensure that they are effectively following complaint procedures.
In the statement released Monday, Schwab leaders called SIP a key component of its advisory lineup that helps clients “invest for the future in a diversified way.” Schwab said the robo-advisor was crafted to provide clients competitive returns while weathering volatility.
“We are proud to have built a product that allows investors to elect not to pay an advisory fee in return for allowing us to hold a portion of the proceeds in cash, and we do not hide the fact that our firm generates revenue for the services we provide. We believe that cash is a key component of any sound investment strategy through different market cycles,” said the statement.
Just days before the SEC fine was announced, Schwab had some time to celebrate an SIP-related win in federal court. Late last week, a proposed class action lawsuit accusing Schwab’s digital advisor of violating its fiduciary duty was dismissed without prejudice in the U. S. District Court for the Northern District of California.
The lawsuit states the approach caused plaintiffs to miss out more than $500 million in market gains they would have enjoyed “had [Charles Schwab Investment Advisors] instead managed their ‘Intelligent Portfolios’ accounts loyally and prudently and without CSIA placing its own interests and those of Schwab before the interests of its clients, as it has done here.”
Senior District Judge Phyllis Hamilton found last week that the court lacks jurisdiction under the Securities Litigation Uniform Standards Act as plaintiffs’ claims were based on state law. But the door remains open for plaintiff’s to refile on different grounds in the future.
Singer, who worked as a regional attorney for FINRA predecessor the National Association of Securities Dealers, believes that if properly disclosed from the start, clients seeking recompense from Schwab’s robo wouldn’t be going to court.
Instead, they would continue their relationship with the Wall Street giant with their complete confidence intact.
“I guess the jaw-dropping thing about Charles Schwab is that many of my colleagues who are in compliance and regulatory and lawyers on Wall Street, we're shocked that Schwab would have resorted to such a silly policy because of the arrogance that they somehow thought that they weren't going to get caught,” Singer said. “This is the danger that Schwab has incurred. It's not that they didn't make their clients on the robo advisor platform money. They did. The problem is the clients now feel that they've been cheated and lied to, and you cannot survive on Wall Street if that's how your client base perceives you.”
He added that clients impacted by actions taken between 2015 and 2018 finally reaching resolution in the form of a big settlement in 2022 is nothing the SEC should be celebrating.
“It's almost half a decade later that the SEC is finalizing these issues,” he said. “I think of what the commission is doing as what I call checkbook regulation, which I would argue is ineffective. Because every press release that comes out of the SEC or the Department of Justice usually tells you that this is the biggest fine in the history of the world. And then the next week there's another one.”
