SEC: Schwab's robo-adviser cash was pre-set for revenue, not by its portfolio methodology; $187m settlement

What happened?

Schwab launched Schwab Intelligent Portfolios (SIP) on 9 March 2015, a robo-adviser that "provides automated, software-based investment portfolio management to clients", according to the SEC order. SIP charged no advisory fee; Schwab instead earned money by placing a fixed share of each portfolio in cash at Schwab Bank and keeping the spread from lending it out.[1][2]

To offer SIP without a fee, management decided the portfolios would hold an average of at least 12.5% cash and set each model portfolio's cash level, from 6% in the most aggressive to 29.4% in the most conservative, based in large part on the revenue Schwab Bank would make. The portfolio construction team treated these levels as fixed constraints. Schwab's internal models showed the cash would reduce returns whenever assets such as equities outperformed cash, by about as much as an advisory fee would have, the SEC found.[2]

From March 2015 to 30 November 2018, the advisers' Form ADV brochures said the cash allocations were "set based on a disciplined portfolio construction methodology" and referred to modern portfolio theory and an "optimal return goal", and Schwab advertised "no hidden fees [and] no advisory fees". The SEC found these statements false or misleading. SEC enforcement director Gurbir Grewal said 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."[1][2][4]

Schwab revised the disclosures and stopped the advertisements on 30 November 2018 after an SEC examination. By then it had profited by almost $46 million from the spread on SIP cash, according to the order.[2]

When did it happen?

1. Mar 9, 2015

   Schwab launches Schwab Intelligent Portfolios with revenue-driven pre-set cash allocations of 6% to 29.4%.[2]

2. Nov 30, 2018

   Following an SEC examination, Schwab publishes a revised ADV brochure and stops the misleading advertisements.[2]

3. Jul 1, 2021

   Schwab discloses a $200 million liability and charge in connection with the expected settlement.[3]

4. Jun 13, 2022

   The SEC issues a settled cease-and-desist order: censure, $45.9m disgorgement plus interest, a $135m civil penalty, a Fair Fund and an independent consultant.[1][2][3]

What was the impact?

• Financial: About $187 million: disgorgement of $45,907,541 plus prejudgment interest (about $52 million together) and a $135 million civil penalty, paid into a Fair Fund for affected investors · ≈ $187 million[1][2][3]
• Other: Schwab profited by almost $46 million from the spread on SIP cash allocations by November 2018. The SEC found the cash lowered clients' returns, under market conditions where equities outperform cash, by about as much as an advisory fee would have; it did not publish a per-client loss figure.[1][2][3]

Severity 4 of 5: Rubric 4 (large losses, consent order): a settled SEC cease-and-desist order with about $187m in disgorgement, interest and a $135m penalty paid into a Fair Fund for robo-adviser clients whose returns the undisclosed cash allocation reduced.

How did The Charles Schwab Corporation (Schwab Intelligent Portfolios) respond?

Schwab said it had resolved "a matter with the SEC regarding certain historic disclosures and advertising related to Schwab Intelligent Portfolios between 2015-2018" and that "in entering the settlement, Schwab neither admits nor denies the allegations in the SEC's Order." It said SIP was designed to provide competitive returns, that the order "acknowledges that Schwab addressed these matters years ago", and that "we do not hide the fact that our firm generates revenue for the services we provide."[3][4]

What was the outcome, and did regulators act?

The SEC censured the three subsidiaries, ordered them to cease and desist from violating the antifraud provisions of the Investment Advisers Act, and required them to pay disgorgement, interest and a $135 million penalty into a Fair Fund for distribution to affected investors, and to retain an independent consultant to review SIP disclosures, advertising and marketing. The sources reviewed do not report the status of the Fair Fund distribution.[1][2][3]

1. Schwab Subsidiaries Misled Robo-Adviser Clients about Absence of Hidden Fees (2022-104) official
   U.S. Securities and Exchange Commission · Jun 13, 2022
   “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”
2. Order Instituting Administrative and Cease-and-Desist Proceedings, In the Matter of Charles Schwab & Co., Inc., Charles Schwab Investment Advisory, Inc. and Schwab Wealth Investment Advisory, Inc. (Advisers Act Release No. 6047) official
   U.S. Securities and Exchange Commission · Jun 13, 2022
   “Also, they falsely claimed that the cash allocations in the SIP portfolios were determined through a "disciplined portfolio construction methodology" when in fact they were pre-set for business reasons, and to compensate Respondents for not charging an advisory fee.”
3. Schwab Statement on Settlement With SEC Related to 2015-2018 Disclosures for Schwab Intelligent Portfolios official
   Charles Schwab · Jun 13, 2022
   “In entering the settlement, Schwab neither admits nor denies the allegations in the SEC's Order.”
4. Charles Schwab subsidiaries to pay $187 million to settle U.S. SEC charges news
   Reuters · Jun 13, 2022