The Securities and Exchange Commission (SEC) has fined three Charles Schwab investment advisor subsidiaries $186.5 million over charges that they intentionally misled clients, made false and misleading statements in their Form ADV filings, and allocated client funds in a way that was less profitable for those clients under most market conditions.
Between March 2015 to November 2018, the company advertised a robo-advisor product, Schwab Intelligent Portfolios, or SIP, that did not charge advisory or have hidden fees.
Schwab also claimed that cash allocations in the SIP portfolios were determined through a “disciplined portfolio construction methodology” and publicly stated that it would seek an optimal return goal for the model portfolios based on the level of risk the investor was willing to take. In reality, cash allocations were preset in order to make up for not charging an advisory fee, the SEC said in an order published Monday.
Schwab believed advertising no-fees gave them a competitive advantage over other robo-advisors, according to SEC. Each of SIP’s model portfolio held between 6 percent and 29.4 percent of client assets in cash — Schwab’s management decided that the SIP portfolios would collectively hold an average of at least 12.5 percent in cash — and were set at a level that would earn a minimum amount of revenue.
“Schwab claimed that the amount of cash in its robo-adviser portfolios was decided by sophisticated economic algorithms meant to optimize its clients’ returns, when in reality it was decided by how much money the company wanted to make,” Gurbir S. Grewal, director of the SEC’s Division of Enforcement, said in a statement.
According to the SEC, Schwab then swept the cash to its affiliate bank, loaned it out, and kept the difference between the interest it earned on the loans and what it paid in interest to the robo-adviser clients, allowing it to profit from its no-advisory-fee policy.
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The commission states that Schwab failed to disclose to investors that under market conditions in which equities outperform cash, the cash allocations in SIP would reduce investors’ returns by about as much as advisory fees would have. In advertising the service as no-fee, Schwab falsely implied that investing in the SIP allowed investors to keep more of their money than they would with competitors that charged a fee.
Schwab’s own internal models showed that under most market conditions, the cash in the portfolios would cause clients to make less money, even as they took on the same amount of risk.
“Schwab’s conduct was egregious, and today’s action sends a clear message to advisers that they need to be transparent with clients about hidden fees and how such fees affect clients’ returns,” Grewal said.
The three Schwab subsidiaries — Charles Schwab & Co., Inc., Charles Schwab Investment Advisory, Inc., and Schwab Wealth Investment Advisory, Inc. — agreed to a cease-and-desist order that prohibited them from violating the antifraud provisions of the Investment Advisers Act of 1940, censured them, and required them to pay approximately $52 million in disgorgement and prejudgment interest, along with a $135 million civil penalty. All penalties will be deposited in a Fair Fund account within 10 days and distributed to harmed clients.
Schwab said in a statement that it neither denied nor admitted to the SEC’s charges. The company said it had addressed issues raised by the SEC years ago and that it was pleased to put the matter behind it.
“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,” Schwab said.
Holly Deaton (@HollyLDeaton) is a staff writer at RIA Intel and based in New York City
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