Charles Schwab Corp. to pay $200 million to the Securities & Exchange Commission regarding Schwab’s automated software portfolio management services

Charles Schwab Corp. shares slid 1.7% Friday, after the brokerage and wealth-management company said it expects to book a charge of at least $200 million in the second quarter relating to a Securities and Exchange Commission investigation of its robo-advisory business.

In a regulatory filing, Schwab SCHW, -3.44% said, without offering further details, that the probe arose from a compliance examination and largely relates to the Schwab Intelligent Portfolios digital advisory business. The charge may be higher, depending on the outcome of the investigation. Robo advisers provide automated, software-based portfolio-management services and have become popular with savers and investors in recent years.

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

Schwab made money from the cash allocations in the robo-adviser portfolios 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 the robo-adviser clients.

“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,” said Gurbir S. Grewal, Director of the SEC’s Division of Enforcement. “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.”

Without admitting or denying the SEC’s findings, Schwab’s 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, censuring them, and requiring them 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 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.

The SEC’s investigation was conducted by Ruth Hawley and John Roscigno and supervised by Jeremy Pendrey and Monique C. Winkler of the San Francisco Regional Office, with assistance from Selvin Akkus-Clemens and Dennis Hamilton of the Division of Economic and Risk Analysis. Examinations of the Charles Schwab entities conducted by Samuel Kim, Rhonda Fan, Nadia Brannon, Daniel Peso, and John Chee of the SEC’s Division of Examinations in the San Francisco Regional Office contributed to the investigation.  

“The company has been cooperating with SEC staff in the investigation and is evaluating its options,” said the filing. A Schwab spokesperson declined to comment beyond the filing.  

The Schwab Intelligent Portfolios division served almost $64 billion in client assets as of March 31, up 51% from a year earlier. Schwab also has a Schwab Intelligent Portfolios Premium product, which includes unlimited guidance from a certified financial planner for a monthly fee, and an Institutional Intelligent Portfolios product that is used by registered investment advisers.

The SEC settled its first cases over robo advisers in December of 2018, charging two advisers, Wealthfront Advisers LLC and Hedgeable Inc., for making false statements about investment products and publishing misleading advertising messages.

JEFFREY NEWMAN, A FORMER PROSECUTOR, IS NOW A WHISTLEBLOWER LAWYER WITH THE FIRM NEWMAN & SHAPIRO, WHICH HANDLES MAJOR SEC WHISTLEBLOWER CASES NATIONWIDE AS WELL AS IRS WHISTLEBLOWERS AND FALSE CLAIMS ACT CASES. HE CAN BE REACHED AT JNEWMAN@NEWMANSHAPIRO.COM OR AT 617-823-3217