Charles Schwab to pay $187 million to settle SEC charges that it misled robo-advisor clients on fees (2024)

The U.S. Securities and Exchange Commission headquarters in Washington.

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Charles Schwab agreed to pay $187 million to settle an SEC investigation into alleged hidden fees charged by the firm's robo-advisor, Schwab Intelligent Portfolios, according to an agency announcement on Monday.

"Robo-advisor" is shorthand for a digital investment service that uses algorithms to judge how to allocate individuals' money among asset classes such as stocks, bonds and cash.

From March 2015 through November 2018, Schwab didn't disclose to clients that its robo-advisor allocated funds "in a manner that their own internal analyses showed would be less profitable for their clients under most market conditions," the SEC claimed.

As part of the settlement, three Schwab subsidiaries — Charles Schwab & Co., Charles Schwab Investment Advisory and Schwab Wealth Investment Advisory — agreed to pay a $135 million civil penalty and an additional $52 million in disgorgement and interest to affected clients.

Cash drag

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Robo-advisors are getting more popular. They began appearing around 2008, during the advent of the iPhone and an ascendant digital culture. They may soon hold more than $1 trillion of Americans' wealth.

The dynamic outlined by the SEC was due to an undisclosed "cash drag" on Schwab client portfolios, the agency said.

Cash generally yields lower returns than stocks, for example, during periods of low interest rates and a rising stock market, as was the directional trend over 2015-2018.

Schwab advertised that clients' cash allocations were determined by strict portfolio methodology that sought optimal returns, according to the SEC. But the firm's data showed that the cash allocations would lead clients to make less money for the same amount of risk in most circ*mstances, the SEC said.

The firm profited by sweeping cash to an affiliate bank, loaning the money and pocketing the difference between the loan interest it received and the cash interest it paid to robo-adviser clients, according to the SEC.

"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," Gurbir S. Grewal, director of the SEC's enforcement division, said Monday.

However, Schwab highlighted that its Schwab Intelligent Portfolios Service lets investors elect not to pay an advisory fee in exchange for allowing the firm to hold some proceeds in cash.

The firm said it "[does] not hide the fact that our firm generates revenue for the services we provide" and thinks cash is a "key component of any sound investment strategy through different market cycles."

As a financial expert deeply immersed in the intricacies of the securities industry, I can unequivocally state that the recent settlement between Charles Schwab and the U.S. Securities and Exchange Commission (SEC) highlights critical issues within the realm of robo-advisors and underscores the imperative for transparency in financial services.

The U.S. Securities and Exchange Commission, or SEC, serves as the primary regulatory body overseeing securities markets and enforcing securities laws. The $187 million settlement agreed upon by Charles Schwab signifies a substantial acknowledgment of wrongdoing, even though the firm neither admitted nor denied the SEC's allegations.

Now, let's dissect the core concepts involved in this article:

Robo-Advisor:
- A robo-advisor is a digital investment service employing algorithms to allocate individuals' funds among various asset classes such as stocks, bonds, and cash.
- Schwab Intelligent Portfolios, in this case, came under scrutiny for allegedly not disclosing its robo-advisor's allocation practices that were deemed less profitable for clients.
Cash Drag:
- The SEC identified a crucial element termed "cash drag" affecting Schwab client portfolios.
- Cash drag refers to the lower returns associated with holding cash compared to other investments, particularly during periods of low interest rates and a rising stock market.
SEC Investigation and Settlement:
- The SEC claimed that from March 2015 to November 2018, Schwab did not disclose to clients that its robo-advisor allocated funds in a manner less profitable under most market conditions.
- The settlement involves Charles Schwab & Co., Charles Schwab Investment Advisory, and Schwab Wealth Investment Advisory paying a $135 million civil penalty along with an additional $52 million in disgorgement and interest to affected clients.
Transparency and Allegations:
- Schwab, while not admitting guilt, agreed to the settlement, emphasizing its commitment to putting the matter behind and focusing on clients' future investments.
- The SEC contended that Schwab's non-disclosure of the "cash drag" was a breach of transparency, negatively impacting clients' returns.
Revenue Generation and Cash Strategy:
- Schwab defended its practices by stating that its Intelligent Portfolios Service allows investors to choose not to pay an advisory fee in exchange for holding some proceeds in cash.
- The firm highlighted that it does not hide its revenue generation mechanisms and views cash as a key component of a sound investment strategy through different market cycles.

In conclusion, this case underscores the evolving landscape of digital investment services, the importance of transparency in financial dealings, and the regulatory role of institutions like the SEC in safeguarding investor interests. It prompts investors to remain vigilant, emphasizing due diligence when engaging with robo-advisors or any financial services.