As Charles Schwab faces a class action lawsuit filed by investors alleging the company breached its fiduciary duty with its robo-advisor’s cash sweeps, one ex-Securities and Exchange Commission attorney says the company is likely going to pull out all the legal stops to defend itself.

“I’m sure that Schwab will vigorously defend against the claims,” said James Lundy, a partner at Faegre Drinker and a former SEC attorney who worked with the Division of Enforcement and the Office of Compliance Inspections and Examinations. Lundy who works with financial advisors on enforcement matters but who is not involved in the suit, spoke with Financial Advisor about Schwab’s position.

Schwab faces a suit by three investors who say that robo-advisor Charles Schwab Investment Advisory put its own interests before those of investors by making cash sweeps to parent company Charles Schwab, causing investors to lose out on as much of $500 million in portfolio growth.

The investors in Schwab’s robo-advisor Intelligent Portfolios accounts claim the firm breached its fiduciary duty to clients by purposely allocating an “imprudent and excessive” amount of investor money into cash—as much as 30%—which cost investors stock market returns while allowing the bank to loan out the money to margin borrowers at interest rates that earned Schwab 5% to 7%. They also said Schwab advertised Intelligent Portfolios as having zero cost to investors without disclosing the firm’s cash sweep practice or the significant revenues it generated.

A Schwab spokesperson declined to comment on the lawsuit.

The class action suit plaintiffs include all Intelligent Portfolios account holders for the four years preceding September 10, 2021 (the filing date for the suit) up until the trial date. In addition to the charge of breach of fiduciary duty, the suit accuses Schwab of breach of contract, unjust enrichment, negligent misrepresentation and unfair business practices.

The case was triggered by Schwab’s disclosure in July that it had set aside $200 million to cover an SEC investigation, Lundy said. “It’s very clear in the class action complaint that they cite the disclosure” as the genesis of the case, he said.

Schwab disclosed that it had incurred a “nondeductible charge of $200 million” and noted that the firm’s actual liability may be different “depending on the outcome of the matter.”

“The SEC has not brought an action against Schwab, nor has there been a settlement yet. Whether or not that happens remains to be seen,” Lundy noted.

But if Schwab does settle with the SEC, it may take the steam out of the class action suit, he added. The plaintiff attorneys, he said, have “hurdles to overcome, such that there may not be customer damages once there is an SEC settlement and reimbursement” for any customers who may have suffered losses due to Schwab’s cash allocations.

Another potential hurdle for the plaintiff attorneys is the fact that they filed the lawsuit under common law, not securities law. “What’s unique about this case is that it is rare for investment advisory businesses to be sued like this, in large part because federal securities laws preclude private rights of action, so this case is being brought under common law,” Lundy explained.

“There is not much precedent for this type of action,” he said. “The only actions the SEC has brought to date was one case in August 2020 and several since. But I don’t think there is any other litigated claim. Clearly these attorneys believe in their claim and filed a case.”

What is certain is that this won’t be the last time the industry hears from regulators and litigators about cash sweeps—“a relatively new revenue stream for the industry,” Lundy said.

“Robo-advice is a new business, and firms are trying to figure out appropriate forms of revenues. In most of the work I do with firms, errors are inadvertent. If they had to do it over again, they would likely make changes.”

In this case, the lack of disclosure about the cash sweeps may be what Schwab regrets. “It’s very clear in this complaint that the plaintiff attorneys cite back to disclosure,” Lundy added. It’s also clear that the new SEC chairman, Gary Gensler, will pursue enforcement in this area, as Jay Clayton did before him.

“I think what we will do is create more specificity in disclosures for robots and all RIAs with regard to cash sweeps, because regulatory interest in the area will only accelerate,” Lundy said.

Adam Gana, a New York City-based securities arbitration attorney and professor at New York Law School, agrees. “All of this underscores the fact that we are currently ripe for legal and regulatory action on robo-advisors, which attract investors based on perceived low costs,” Gana said.

The importance of these types of lawsuits “is they set the contour of how courts will interpret best interest going forward. The court will have to opine on whether Schwab met their fiduciary standard and that will set the best interest legal standard for future arbitrations as well. That’s a good thing,” Gana added.

One independent advisory firm that uses Schwab for trades agrees with that assessment.

“What the heck took them so long? Everyone knew this was an issue and I'm glad it will now be rectified,” said Charles Sachs, chief investment officer of Kaufman Rossin in Miami.

“Younger investors are attracted to robo-advisors,” Sachs said, “and unless they tell you different, there is no legitimate reason to park investors in that much cash. You’re locking in 2% to 3% annual losses due to inflation. Investors are on the losing end of this practice.”