The Case of Charles Schwab and the Concept of SEC Regulation of Robo-Advisers

Automated digital investment advisory programs, often referred to as “robo-advisers”, have grown in popularity over the last decade since their initial introduction in 2008. (SEC; Investopedia). As a digital financial adviser, a robo-adviser manages investments with minimal human intervention. (Milan Ganatra, Aashika Jain, Forbes). Robo-advisers provide automated investment portfolios based on the investor’s imputed preferences, risks, and goals by using advanced algorithms that analyze investor information. (Id.; Charles Schwab). While this technology is a considerable advancement and is accurate most of the time, it is not without its drawbacks and risks. For example, what happens if these robo-advisers provide clients with “misleading” information?

The Securities and Exchange Commission’s (“SEC’s”) latest order against brokerage giant Charles Schwab (“Schwab”), offers insight. (Jacob Bogage, The Washington Post). Schwab currently boasts $7.28 trillion in client assets, $460 billion of which are expected to be managed by robo-advisers in 2022. (Charles Schwab). The question now arises whether this predication will change following the SEC’s latest order requiring Schwab to pay a $187 million – a $135 million civil fine, as well as $52 million in disgorgement and prejudgment interest payments to harmed clients who the SEC claims were misled by the company’s robo-advisers. (Jacob Bogage, The Washington Post; Derek Saul, Forbes).

Schwab’s robo-advisers operate by weighing an investor’s time horizon, financial goals, and risk tolerance against the unpredictable forces of asset class performance, market volatility, and market conditions to automatically recommend a portfolio. (Charles Schwab). With Schwab, an investor will complete a questionnaire to assess their risk tolerance and investment needs. Id. From those responses, the robo-adviser will automatically build a suggested diversified portfolio of funds, which Schwab claims is usually selected by a team of investment professionals. Id. Schwab also claims that they have experts regularly monitoring market activity and every underlying investment to ensure that the model portfolio produced by the robo-adviser is rebalanced appropriately. Id.  

Because robo-advisory services have low starting deposits and do not require that investors possess in-depth market knowledge, they are an enticing option for novice investors to achieve their specific investment goals. Id. For experienced investors, robo-advisers are also popular because of their ability to automate complex, time-consuming activities like rebalancing and tax loss harvesting. Id. In using a mathematical algorithm to assess the investor, robo-advisers decrease the possibility that a model portfolio is produced with bias and partiality. (Milan Ganatra, Aashika Jain, Forbes).

Although the services robo-advisers provide are automated, robo-advisers are typically SEC-registered investment advisers subject to the substantive and fiduciary requirements and obligations set forth by the Investment Advisers Act of 1940 (the “Advisers Act”). (SEC). Under the Advisers Act, an investment adviser is required to fully disclose all material facts to clients and employ reasonable measures to avoid misleading clients. Id. This helps to ensure transparency by providing clients with the necessary information they need to make fully informed investment decisions. Id. This is particularly important for robo-advisers since clients in these types of investment relationships rely solely on their robo-adviser to electronically communicate limitations, risks, and operational aspects of the advisory service. Id.

On June 13, 2022, the SEC charged three Schwab registered investment adviser subsidiaries, Charles Schwab & Co., Inc., Charles Schwab Investment Advisory, Inc., and Schwab Wealth Investment Advisory, Inc., for misleading robo-adviser clients within their mandatory disclosures. (SEC). The SEC order states that Schwab made false and misleading statements to investors by failing to disclose they were allocating client funds in a manner that their internal analyses showed would be less profitable under the majority of market conditions. (Id.; Jacob Bogage, The Washington Post). According to the SEC, Schwab’s mandated disclosures for its robo-adviser product, Schwab Intelligent Portfolios, stated from March 2015 to November 2018 “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 returns[s]’”. Id. However, Schwab’s own internal data directly showed that under most market conditions allocating client assets to cash investments would result in causing clients to make less money despite taking on the same amount of risk, creating a discrepancy. (Id.; Derek Saul, Forbes).

Gurbir S. Grewel, the SEC’s division of enforcement director, stated that, “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”. (SEC). The SEC alleges that Schwab directly made money from these cash allocations in the robo-adviser portfolios from loaning it out through Schwab’s affiliate bank and keeping the difference between the interest Schwab earned on the loans and what Schwab paid in interest to the robo-adviser clients. Id. While Schwab advertised their robo-adviser program as having no advisory or hidden fees, Schwab failed to disclose to clients about the cash drag that would occur on their investments. (Id.; Jacob Bogage, The Washington Post). The SEC alleges that Schwab directly misled robo-adviser clients by failing to inform them that a portion of their portfolio would be held in cash instead of being fully invested into the market. Id.

Since bringing forth their first two enforcement actions against robo-advisers in December of 2018, the SEC has generally been successful with their enforcement cases. (Julie DiMauro, Reuters). Typically, SEC charges against investment firms employing robo-advisers are regarding absent or misleading disclosures in relation to advertising and solicitation. Id.Similar to the Schwab case, the SEC charged Wahed, a New York based financial technology and services company, earlier this year for making misleading statements about their robo-advisers. Like Schwab, these statements conflicted with the statements disclosed to investors. (SEC).

In 2017, the SEC launched a specific guidance program to help firms using robo-advisers navigate compliance with the Advisers Act. However, considering the extent of the SEC’s continued enforcement actions, it seems that the current regulatory scheme does not sufficiently protect investors from potential dangers posed by robo-advisers. Specifically, the SEC’s latest order against Schwab emphasizes the risks investors take when using robo-advisers because of the lack of transparency that continues to plague the investment industry.