SEC Brings Action Against Investment Advisers For Allegedly Misleading Robo-Adviser Clients About Hidden Fees
On June 13, 2022, the Securities and Exchange Commission (“SEC”), announced that it had instituted a settled administrative proceeding accusing several investment advisers (the “Advisers”) that focused on robo-advising, and all of which were themselves subsidiaries of a prominent investment adviser, of violating Sections 203(e) and 203(k) of the Investment Advisers Act of 1940 and Section 15(b) of the Securities Exchange Act of 1934. Broadly, the SEC accused them of failing to invest client cash in ways that their own analyses showed would be optimal for the clients, and instead retaining cash in a way that benefitted the Advisers. The Advisers did not admit or deny the SEC’s allegations as part of the resolution, but as part of the settlement agreed collectively to disgorge approximately $52 million and to pay a civil monetary penalty of $135 million and were also required to engage an independent consultant and engage in certain other undertakings.
According to the allegations in the SEC Order, from March 2015 through November 2018, the Advisers made misleading statements on Form ADV and in the Advisers own advertisements with respect to the fixed rate of cash held in the Advisers’ robo-adviser products (the “Accounts”) and failed to disclose a potential conflict of interest between the Advisers and investors regarding the performance of the Accounts. It is further alleged that beginning in March 2015, the Advisers promoted the Accounts, in part, on the basis that they did not charge fees to investors. Rather than charge clients fees, the Accounts allegedly held pre-determined percentages of cash from which the Advisers could not deviate; the cash allegedly was distributed to the Advisers’ affiliate, which loaned out the cash at higher rates than was paid to the clients, allowing the Advisers and their affiliates to generate income from the Accounts. The SEC alleged that the Advisers did not inform investors that holding a fixed rate of cash, which ensured consistent fee generation for the Advisers, and created scenarios in which the Accounts’ performance would be lower than it would be through modifying the rate of cash. According to the SEC, under certain market conditions, specifically where equities outperform cash, the Accounts would not generate the same returns for investors as compared to if they did not hold fixed rates of cash. The SEC alleged the Advisers’ internal models identified this potential performance issue, referred to as “cash drag,” but that the Advisers did not disclose the issue to potential investors at the time the Accounts were put on the market.
According to the SEC Order, a few weeks prior to the release of the Accounts, the draft marketing materials did disclose the fixed cash rates and potential conflict of interest between the Adviser and clients. However, in February 2015, two media articles were published that were highly critical of robo-adviser models creating cash drag, which the SEC alleged induced the Advisers’ leadership to have the marketing materials re-drafted in a manner that did not clearly identify the potential conflict or pre-set fixed rate of cash, and instead suggested the Accounts’ portfolio holdings were set based on an algorithm creating a disciplined portfolio methodology.
The Advisers jointly agreed to pay approximately $52 million in disgorgement and a $135 million civil penalty. Although the Advisers neither admitted nor denied the SEC’s claims, as part of the settlement they committed to remedial next steps, including a comprehensive compliance review, hiring an independent consultant to revise their policies, and undertaking significant recordkeeping for future SEC inquiries.