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Enforcement News: SEC Charges Investment Advisory Firm with Making Material Misstatements and Omissions in Connection with Its Automated Tax Loss Harvesting Service

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  • Posted on: Apr 26 2023

By: Jeffrey M. Haber

Taxes. Everyone hates paying them. 

As one might expect, taxpayers often look for any opportunity to minimize their tax obligation. When securities are involved, especially in taxable accounts, a taxpayer may look to his or her broker or investment adviser to develop strategies that will mitigate the tax impact of their investments. An investment adviser may, for example, replace a security with an unrealized loss with another security to capture the tax benefit while maintaining a similar exposure and allocation in the client’s account. Such a strategy was at the center of a settlement between the Securities and Exchange Commission (“SEC”) and Betterment LLC (“Betterment”), a New York-based investment adviser.

Among other things, Betterment provides investment advice by offering portfolio strategies to clients. The portfolio strategies consist primarily of exchange traded funds (“ETFs”) that provide exposure to different asset classes. Betterment also provides automated, software-based portfolio management on a discretionary basis. Betterment offers its services to retail clients, who use Betterment through third-party investment advisers, and retirement plans and their participants. 

Since 2014, Betterment has offered its tax-loss harvesting service (“TLH”) to clients that have taxable accounts. TLH is an automated, algorithm-driven process whereby individual positions in client taxable accounts are scanned to identify unrealized investment losses. If, after meeting certain conditions, an ETF is identified where a client has an unrealized loss that could potentially be used to reduce their liability, it is sold and replaced with a closely correlated ETF with similar exposure. In other words, TLH is designed to replace a security with another security to capture a potential tax benefit while maintaining a similar exposure and allocation in a client’s account. 

To take advantage of TLH, a client must enable the service. Since its introduction through January 2023, over 275,000 client accounts have enabled TLH.

On April 18, 2023, the SEC announced (here) that it charged Betterment with making material misstatements and omissions related to TLH, failing to provide clients with notice of changes to contracts, and failing to maintain certain required books and records. Betterment settled the charges, agreeing to pay a $9 million penalty and to distribute funds to affected clients.

According to the SEC, from 2016 to 2019 (the “Relevant Period”), Betterment misstated or omitted several material facts concerning TLH. For example, Betterment described TLH as a service that scanned a client’s account on a daily basis for harvesting opportunities. 

Due to constraints related to overall client trading volume, explained the SEC, Betterment adjusted its TLH scanning frequency in January 2016. Betterment separated clients into two groups and scanned their accounts on alternating trading days. The SEC found that Betterment did not perform any contemporaneous analysis to evaluate the potential impact of the change on clients, and clients that used TLH were not notified of the change. According to the SEC, reducing TLH’s scanning frequency can reduce the benefit of the service, depending on a number of client and market specific factors.

 On April 24, 2019, Betterment determined that its trading system could revert back to daily scanning and reinstituted daily scanning for all clients with TLH enabled as of that date.

During the Relevant Period, said the SEC, approximately 25,000 clients lost approximately $1.9 million in potential tax benefits as a result of the undisclosed change in scanning frequency.

In addition, the SEC found that Betterment failed to disclose a programming constraint with TLH that affected certain clients. 

According to the SEC, the TLH algorithm imposed certain restrictions on harvesting activities for multiple-portfolio clients. Because some third-party managers used the same ETFs in their portfolio strategies as Betterment did, there was a risk of certain negative tax implications stemming from transactions in these overlapping ETFs. Betterment designed the TLH algorithm with constraints intended to minimize these negative tax consequences. 

The SEC explained that asset classes, which were eligible for TLH, were assigned up to three closely correlated ETFs (ranked as primary, secondary, and tertiary choices), which could be used as replacements in TLH transactions. In some instances, the ETFs in a particular asset class overlapped between two portfolio strategies, but were ranked differently, which created the risk of a potential negative tax consequence from a harvest. Betterment restricted TLH from harvesting in asset classes where that type of overlap existed to avoid the risk of a potential negative tax consequence. As a result, said the SEC, TLH activity, and potentially TLH results, could differ significantly for multiple-portfolio clients as compared to clients who selected a single portfolio strategy.

According to the SEC, the constraints associated with overlapping securities were not described in Betterment’s client disclosures. In fact, said the SEC, one disclosure suggested that TLH would not function any differently between a single portfolio strategy and a multiple-portfolio strategy. 

In January 2019, Betterment made the interaction between TLH and third-party portfolio strategies clearer when it updated a disclosure statement it provided to clients that enabled TLH. The notification, said the SEC, did not attempt to quantify whether a client was adversely affected, and offered no remediation. 

According to the SEC, from September 2017 until January 2019, there were approximately 5,600 multiple-portfolio client accounts that enabled TLH. At least 3,200 client accounts lost approximately $1 million in potential tax benefits as a result of the undisclosed constraints in the design of TLH.

Finally, Betterment failed to disclose two computer coding errors that prevented TLH from harvesting losses for some clients. The SEC found that beginning in April 2016, a coding error caused two Betterment client databases to cease interfacing properly for certain accounts. The result, said the SEC, was that for at least 150 accounts, TLH was disabled although clients had enabled it. Consequently, noted the SEC, Betterment did not scan these accounts or harvest any tax losses until the coding error was fixed.

According to the SEC, in January 2019, Betterment learned about and fixed the coding error after an inquiry from a third-party investment adviser. Betterment attempted to notify impacted clients and remediate the issue, but those efforts were incomplete. 

The SEC found that beginning in November 2015 until June 30, 2018, Betterment experienced another coding error related to over 600 client accounts that were titled as joint trust accounts. Similar to the other coding error, this error caused TLH to be disabled for clients that had enabled the service. Betterment similarly learned about the issue as a result of a client inquiry, in June 2018, and fixed the coding error shortly thereafter. However, said the SEC, Betterment did not notify any other affected client or provide remediation because it concluded that the issue did not adversely impact clients. As noted by the SEC, that was an incorrect determination.

The SEC found that together, the coding errors impacted approximately 760 client accounts. At least 700 client accounts were negatively impacted and lost approximately $1.1 million in potential tax benefits during the Relevant Period.

Collectively, said the SEC, the disclosure and coding issues adversely impacted more than 25,000 client accounts, resulting in those clients losing approximately $4 million in potential tax benefits.

The SEC further found that Betterment failed to provide advance notice of changes to its advisory contract, which is a violation of its fiduciary duty as an investment adviser, and failed, during certain times, to maintain accurate and current books and records reflecting written agreements with certain clients. Also, the SEC found that, in connection with the failures related to TLH, Betterment failed to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940.

Commenting of the settlement, Antonia M. Apps, Director of the SEC’s New York Regional Office, stated: “Robo-advisers have the same obligations as all investment advisers to ensure they are transparent about services they provide and upfront about any material changes to those services or issues that may negatively affect clients. Betterment did not describe its tax loss harvesting service accurately, and it wasn’t transparent about the service’s changes, constraints, and coding errors that adversely impacted thousands of clients.”

Betterment consented to the entry of the SEC’s order finding that it violated Sections 204, 206(2), and 206(4) of the Investment Advisers Act of 1940 and related rules. Without admitting or denying the SEC’s findings, Betterment agreed to a cease-and-desist order (here), a censure, and to pay a $9 million civil penalty that will be distributed to affected clients.

Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.

This article is for informational purposes and is not intended to be and should not be taken as legal advice.

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