Better Meant Than Delivered: SEC Sanctions Failed Tax Loss Harvest
Tax loss harvesting (“TLH”) is a well-recognized investment discipline, as Julia Kagan writes in her article “Tax-Loss Harvesting: Definition and Example” on Investopedia:
Tax-loss harvesting is the timely selling of securities at a loss to offset the amount of capital gains tax owed from selling profitable assets.
Indeed, TLH is offered by any number of investment firms. BlackRock, Charles Schwab, Fidelity Investments, Vanguard, Goldman Sachs Asset Management, Morgan Stanley, Wealth Front, and Merrill Lynch are just a few of the firms that offer TLH investment services on the Internet. A successful TLH program requires regular, ideally daily, portfolio review to identify candidates for sale at a loss to balance off gains from the sale of profitable positions. In addition, as noted in the Kagan article, care must be taken to avoid so-called “wash sales,” where a security is sold at a loss, but then repurchased within 30 days – resulting in a denial of tax benefits from the loss sale. If this were all done manually (as it once was), TLH would be quite labor intensive AND expensive, probably sufficiently valuable only for investors with very large positions. Of course, individual investors CAN do the necessary determination of securities to sell at a loss to offset gains realized from selling other holdings, but some investors, especially those with large holdings, can enroll in programs that will propose those transactions automatically.
That automated service has been made possible with the development of computerized trading programs that carry-out the monitoring and even the execution of TLH sales. This development is an example of “Artificial Intelligence” at work. But what if the “Intelligence” is faulty? The U.S. Securities and Exchange Commission (“SEC”) identified this as a particular risk for investors. Indeed, the SEC’s Division of Examinations (“EXAMS”), in its 2021 Examinations Priorities Report, announced that it would pay particular attention to these automated systems to make as certain as possible that investors:
- are accurately informed of any risks; and
- actually receive the services being advertised.
I have previously written about the intended scrutiny of such “robo-advisers” in my blog “‘I Robot’: SEC Evaluates the First Law of Robotics.” See Isaac Asimov, 1950 short story “I, Robot” (“A robot may not injure a human being or, through inaction, allow a human being to come to harm.”) Now EXAMS has found a culprit, Betterment LLC, which failed to live up to its name with regard to over 25,000 client accounts from 2016 to 2019. Those failures resulted in the affected clients missing out on some $4 million in potential tax benefits.
Betterment LLC, a Delaware limited liability company based in New York City, has been registered with the SEC as an investment adviser since 2009, and as of March 30, 2022, it had $33.8 billion in assets under management. According to Barbara A. Friedberg in a review for Investopedia, “Betterment is our best robo-advisor for beginners and best for cash management.” On its own website, Betterment styles itself as “the largest independent wealth advisor” in the U.S. markets. Beginning in 2014, Betterment offered TLH to clients with taxable accounts (as opposed to exempt accounts such as IRAs). Clients who elected to use the TLH service would grant Betterment access to their invest portfolios, where according to the SEC’s April 2023 Order Instituting Administrative and Cease-And-Desist Proceedings (the “Order”), Betterment’s “…automated algorithm-driven process…” scanned participating client accounts to identify unrealized investment losses. The Order notes that over 275,000 client accounts were enrolled in the Betterment TLH program through January 2023. In the Order, the Commission identifies three operational shortfalls of the Betterment system from 2016 through correction in 2019:
- change of the frequency of account scanning;
- undisclosed constraints for client accounts using third-party portfolio strategies; and
- undisclosed coding errors that prevented account scanning.
Betterment’s disclosure materials consistently asserted that the TLH scanning would occur daily. But due to increased growth of trading volume in 2016, Betterment split participating client accounts into two groups and scanned each group on alternate trading days. According to the Order, this was done without any analysis to measure the impact of this unannounced change. Nor did Betterment have in place policies and procedures to require periodic review of its disclosures. Only in late April 2019 was daily scanning reinstituted. The Commission asserts that this undisclosed scanning change caused clients to miss out on $1.9 million in tax benefits. Beginning in September 2017, Betterment allowed clients to use its TLH program even when using a third-party portfolio strategy, but it did not disclose that its TLH system had certain built-in constraints (primarily designed to avoid wash sale transactions).
In January 2019, after inquiry from a third-party entity, Betterment revised the disclosure to note the existence of the constraints and the potential for fewer tax-loss harvesting opportunities. Before the corrective disclosure, Betterment clients lost out on some $1 million of tax benefits. After April 2016, a coding error prevented tax-loss harvesting in some 150 particular accounts, which Betterment discovered after the inquiry from the same third-party entity. A further coding error prevented the tax-loss harvesting in some 600 joint trust accounts until discovery after inquiry in June 2018. A total of 760 affected accounts missed out on around $1.1 million in tax benefits.
In addition to the operational failures just described, the Betterment advisory contract was non-compliant until February 2023, as it permitted Betterment to change even material terms of the contract without advance notice. The client had to visit the firm’s website periodically to learn of any amendments. The Order notes that in March 2023, Betterment revised the contract for all clients to require advance notice of material changes. During the Commission’s investigation of Betterment, the firm was unable to provide “accurate and current records” of client agreements enabling the TLH program and further did not have accurate and current records of client agreements selecting third-party portfolio strategies.
Finally, as noted above, Betterment did not have adequate policies and procedures to identify problems, including “necessary communications between its compliance personnel, who review disclosures, and its engineers, who design and update its algorithms.” This last deficiency invokes the observations of the British scientist and novelist, C. P. Snow, who in his book Rede Lecture (1959) observed that science and the humanities had been split into two cultures whose inability to communicate effectively with each other impeded both.
In any event, the SEC determined that Betterment violated Section 206(2) of the Investment Advisers Act of 1940 (the “1940 Act”), as amended, which bars an investment adviser from engaging in any transaction, practice, or course of business that operates as a fraud on a client. Betterment also violated Section 206(4) of the 1940 Act and Rule 206(4)-7 thereunder for failing to have required policies and procedures to prevent 1940 Act violations. Finally, Betterment violated Section 204 of the 1940 Act and Rule 204-2(a)(10) thereunder, which require the preservation of records including agreements with clients. As a result, Betterment was ordered to cease and desist from future violations of those Sections and Rules; Betterment was censured; and Betterment was ordered to pay $9 million as a penalty, to be deposited in a Fair Fund to provide reimbursement to the adversely affected Betterment clients, pursuant to a plan proposed by Betterment and approved by the Commission. Betterment is required to administer the approved plan and to provide a written report on the administration and distribution of the Fair Fund within 150 days, with any undispersed funds to be sent to the Commission.
It is noteworthy (as reported in the Commission’s April 18, 2023 Press Release concerning this matter) that the Betterment failures were discovered by personnel from EXAMS and that the ensuing SEC investigation was assisted by the Quantitative Analytics Unit of EXAMS. Despite Betterment’s size and reputation, there is a “Keystone Kops” quality to the violations cited by the SEC in the Order, a quality suggesting too rapid growth and too little investment in compliance. One may hope that the respondent here will operate in the future in a way that is more consistent with its name.
If you have any questions concerning this post or any related matter, please feel free to contact me at pdhutcheon@norris-law.com.