On June 30, 2021, the Financial Industry Regulatory Authority (“FINRA”) fined[1] the popular broker-dealer trading app Robinhood Financial LLC (“Robinhood”) $57 million, and ordered the company pay approximately $12.6 million in restitution, for what FINRA alleges were “systemic supervisory failures.”[2] FINRA’s settlement with Robinhood stems from numerous FINRA rules violations, including infractions related to Robinhood making false or misleading information directed to customers, widespread systems outages on its trading platform, and Robinhood’s approval of customers to trade options when it was not appropriate to do so. FINRA’s sanctions against Robinhood represent the largest financial penalty ordered by the regulator.
As it prepares for its IPO later this year, FINRA’s recent penalties represent only a small portion of the state/federal investigations and private lawsuits Robinhood faces for various forms of alleged regulatory misconduct. The popular FinTech startup, whose stated mission is to “democratize and de-mystify finance for all,” and to “make investing friendly, approachable, and understandable for newcomers and experts alike,”[3] now faces substantial growing pains as it aims to be a serious broker dealer competitor on Wall Street for a younger generation of individual investors. These regulatory and legal hurdles not only throw a wrench in Robinhood’s plans to go public, but also shake users’ confidence in the company, which had long prided itself on appealing to “a new generation of investors who are more comfortable trading on smartphones.”[4]
Background on Robinhood
Robinhood, which launched online trading in December 2014, is a popular FinTech broker that offers and pioneered the novel idea of “commission free” trades. The company gained popularity among relatively young, and inexperienced retail investors through its easy to use trading platform which is available on both a website and mobile app version. As a testament to its popularity, Robinhood experienced dramatic growth—from fewer than 500,000 customers in 2015 to over 31 million in 2021. Attesting to the relative youth, lack of trading experience, and popularity among retail investors, according to the settlement, as of February 2021, the median age of Robinhood’s customers was 31, and approximately half of its customers self-identified as first-time investors. The median customer account size was approximately $240, and the average account size was approximately $5,000.
Previous Run-Ins with Financial Regulators
Robinhood’s recent FINRA penalty is not the first time the company has been caught violating financial industry regulations. In December 2019, Robinhood settled with FINRA, where it consented to findings that, from October 2016 through November 2017, the company violated numerous FINRA rules by not exercising reasonable diligence to ascertain that the broker-dealers to which it routed customer orders for payment for order flow provided the “best execution” quality as compared to other execution venues and by not having a reasonably designed supervisory system to achieve compliance with its “best execution” obligations under FINRA’s rules. This resulted in a censure and $1.25 million fine. In December 2020, Robinhood settled with the SEC, where it consented to findings for similar misconduct in violation of the Securities Act of 1933, the Securities Exchange Act of 1934, and Rule 17a-4 thereunder. The SEC imposed a $65 million penalty.
Misconduct and FINRA Rules Violations[5]
As part of its investigation, FINRA found that despite Robinhood’s self-described mission to “de-mystify finance for all,” since September 2016, Robinhood “negligently communicated false and misleading information to its customers.” The false and misleading information concerned a variety of issues, including whether customers could place trades on margin, how much cash was in customers’ accounts, how much buying power or “negative buying power” customers had, the risk of loss customers faced in certain options transactions, and whether customers faced margin calls. Robinhood also displayed to certain other customers inaccurate negative cash balances. Due to these misstatements, thousands of customers suffered more than $7 million in losses. As part of the settlement, Robinhood is required to pay restitution. As a result of these and other false and misleading statements, Robinhood violated FINRA Rule 2010, which prohibits FINRA member firms from making misrepresentations to customers. Robinhood’s negligent dissemination of false and misleading information to its customers separately violated FINRA Rules 2210 and 2220, which set forth content standards for firms’ communications with customers. Because Robinhood also failed to have a reasonably designed supervisory system and procedures to achieve compliance requiring that communications with customers be truthful and not misleading, it also violated FINRA Rules 3110 and 2010.
FINRA’s investigation additionally found that since Robinhood began offering options trading to customers, it often failed to exercise the requisite due diligence before approving customers to place complex options trades—which unlike normal stock trading, are more intricate, and often require substantial knowledge and market familiarity that many retail investors lack. These actions violated FINRA Rules 3110, 2360, and 2010. Robinhood relied on algorithms (i.e., “option account approval bots”) to approve customers for options trading, with extremely limited oversight by Robinhood. These “bots” then approved customers to trade options based on inconsistent or illogical information. As a result, Robinhood approved thousands of customers for options trading who either did not satisfy the firm’s eligibility criteria or whose accounts contained glaring red flags indicating that trading options was not appropriate. Options trading on Robinhood spiked during winter 2021—which famously saw the meteoric rise of GameStop (NYSE: GME) and other brick and mortar retail store stocks linked to promotion by investors on Twitter and Reddit which swarmed to Robinhood’s easy to use trading platform.
FINRA’s investigation also found that, from January 2018 to February 2021, Robinhood failed to reasonably supervise the technology that it relied upon to provide core broker-dealer services (i.e., accepting and executing customer orders) in violation of FINRA Rules 3110 and 2010. Between 2018 and late 2020, Robinhood experienced a series of outages and systems failures. The most serious outage occurred on March 2-3, 2020, when its website and mobile app shuttered, preventing customers from accessing their accounts. Although Robinhood had a business continuity plan (“BCP”), FINRA found that Robinhood did not apply it because the BCP was limited to events that only impacted the company’s physical location. These actions violated FINRA Rules 4370 and 2010. Robinhood’s inability to process customer orders during these outages resulted in individual customers losing tens of thousands of dollars. As part of its restitution penalty, FINRA required Robinhood to pay restitution to affected customers.
Finally, FINRA’s investigation found that between January 2018 and December 2020, Robinhood failed to report thousands of customer complaints in violation of FINRA Rules 4530(d) and 2010. These included complaints that Robinhood provided customers with false and misleading information, and that customers suffered losses as a result of the firm’s outages and systems failures. According to FINRA, the reporting failures were primarily the result of a company policy that exempted certain categories of complaints, even though those categories fell within the scope of what was required under FINRA regulations. The settlement also resolves numerous other charges against Robinhood, including their failure to have a reasonably designed customer identification program in violation of FINRA Rules 3310 and 2010; as well as the company’s failure to display complete market data information on its website and mobile app as required by Rule 603(c) of Regulation NMS of the Exchange Act, and in violation of Rule 603(c) and FINRA Rule 2010.
Conclusion
All told, FINRA levied a censure, a $57 million fine, approximately $12.6 million in restitution, retention of a third-party consultant, and a certification requiring Robinhood cease from making false or misleading statements. Civil regulatory penalties for violating SEC and FINRA regulations are nothing new for Wall Street firms. “Big Banks” and broker dealers are constantly being slapped with penalties for conduct as mundane as mere technical violations to egregious market manipulation and antitrust cartels. But Robinhood was supposed to be different from the stuffy, old Wall Street brokerage houses of the past. Robinhood was the trendy, new FinTech startup bucking the mold and changing the game. Back in 2014, Robinhood disrupted the industry model that Wall Street had relied on for years by offering revolutionary commission free trades. As a result, the industry reacted, and now most big brokerages offer them. Robinhood found a target audience in millennials who found Robinhood’s trading platform easy to use and a convenient way to invest. Afterall, this was the generation who had come of age during the 2008 financial crisis and watched as Wall Street banks seemed to get away with their unscrupulous conduct. Thus, Robinhood filled the void where younger, individual investors had distrust for these traditional firms. Put simply, Robinhood made investing FUN for a new generation of first-time investors who just as easily rely on their smartphones to order food and connect with friends on social media, as they do to place a trade on their favorite stock
While Robinhood may have partly achieved its goal to “democratize” finance and level the playing field, it has now found itself at a crossroads and in the crosshairs of regulators. The allegations brought by FINRA paint the picture of a company with sloppy compliance, a disregard for regulations meant to protect consumers, and an aggressive business model targeted at capturing new investors, even if those investors are not necessarily familiar with trading complex and volatile options. As the company stares down the barrel of regulators as it seeks to go public later this year, whether the company truly reforms its practices and harkens back to its mission statement is yet to be seen. One thing is certain, Robinhood has certainly shaken up the Wall Street paradigm of stock trading, for better or for worse.
[1] As part of the settlement, pursuant to FINRA Rule 9216, Robinhood submitted a Letter of Acceptance, Waiver, and Consent (“AWC”) for the purpose of proposing a settlement of the alleged rules violations. This was submitted on the condition that, if accepted, FINRA would not bring any future actions against Robinhood based on the factual findings of the AWC. Robinhood neither admitted nor denied FINRA’s allegations but opted to resolve the investigations through a fine and restitution—a decision that was likely connected to resolving its liabilities before its forthcoming IPO later this year.
[2] FINRA Letter of Acceptance, Waiver, and Consent Against Robinhood Financial, LLC, No. 2020066971201 (June 30, 2021), at 28. https://www.finra.org/sites/default/files/2021-06/robinhood-financial-awc-063021.pdf.
[3] Id. at 2.
[4] Chris Matthews, Before Congress, Robinhood CEO Vlad Tenev to reject accusation that app encourages reckless trading, MarketWatch, Feb. 17, 2021, https://www.marketwatch.com/story/before-congress-robinhood-ceo-vlad-tenev-to-reject-accusation-that-app-encourages-reckless-trading-11613602537.
[5] Press Release, FINRA, FINRA Orders Record Financial Penalties Against Robinhood Financial LLC (June 30, 2021), https://www.finra.org/media-center/newsreleases/2021/finra-orders-record-financial-penalties-against-robinhood-financial.