A federal regulator is smiting a publicly traded brokerage for nine figures over disclosures related to the firm's roboadvisor business. Other asset managers, especially those in the roboadvisor and banking businesses, may want to take heed.

Walter William "Walt" Bettinger II Charles Schwab & Co. President, CEO

On Monday, Gurbir Grewal, director of the division of enforcement at the U.S. Securities and Exchange Commission (SEC), confirmed that the SEC has charged three Charles Schwab units with violating the antifraud provisions of the Investment Advisers Act of 1940. Schwab settled the charges with the SEC without admitting or denying the findings, and the brokerage will pay $186.5 million (including $51.5 million in disgorgement with interest, plus a $135-million civil penalty). (See the 15-page order.)

The case focuses on the first three years of the Schwab Intelligent Portfolios (SIP) roboadvisor service, which launched back in 2015. The SEC focuses in particular on the fact that SIP was marketed as being no fee (unlike most roboadvisors, which charge a specific fee in bps) and that Schwab makes money banking style off of the spread from using SIP's cash allocation for lending purposes (also unlike most roboadvisors, which don't tend to have banking arms).

According to the SEC, Schwab misled SIP investors by saying that allocations to cash were through a "disciplined portfolio construction methodology" instead of revealing that the allocations were set at certain levels to generate specific amounts of revenue from the cash spread. And the Schwab team also advertised SIP by specifically contrasting it with roboadvisors that charge explicit fees.

"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," Grewal states. "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."

"Schwab has resolved a matter with the SEC regarding certain historic disclosures and advertising related to Schwab Intelligent Portfolios between 2015-2018, and we are pleased to put this behind us. The SEC Order acknowledges that Schwab addressed these matters years ago," the Schwab team states. "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."

It's worth noting that the SEC's order makes no mention of the fact that SIP is predominantly invested in ETFs, specifically ETFs from Schwab itself; presumably has adequately disclosed and/or mitigated that apparent conflict of interest. So asset managers that have roboadvisor affiliates can rest easy if they don't also own banks.

The SEC seems to be treating the spread on cash deposits here as a kind of fee, and it's true that it's a source of revenue. Yet unlike fees, that spread is not set in stone but variable, and that spread is at the core of how banking works. Of course, banking practices are normally overseen by a different regulator, the OCC, but the combination of banking with roboadvice is how the SEC comes in.

From looking at the SEC's order, it appears that, for roboadvisors going forward, they could potentially avoid a similar regulatory smiting in a variety of ways:
1) By not allocating cash to banking affiliates;
2) By clearly disclosing that allocating cash to a banking affiliate is a way to generate revenue;
3) By not advertising their services as free or no-fee; or
4) By disclosing that allocations to cash are set at specific levels to generate minimum revenue and disclosing how such allocations potentially affect overall returns. 

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