Robinhood’s Lengthy Means Out of Sherwood Forest | Burr & Forman

On Thursday, January 28, trading-app broker-dealer Robinhood – a self-styled disrupter democratizing trading – suspended its users’ ability to buy Gamestop stock or options (along with other stocks). After playing a prominent role in the crowd-sourced short-squeeze on the meme stock, abruptly shutting the “buy” door prompted swift and fierce reactions. NY Rep. Alexandria Ocasio Cortez tweeted that Robinhood’s freeze on Gamestop buys was “unacceptable” and called for Congressional hearings. Texas Sen. Ted Cruz quickly agreed (eliciting a snarky tweet-for-tat response). Other members of Congress piled on.

Massachusetts Sen. Elizabeth Warren took up the grievance, citing Robinhood’s recent regulatory history (more on that below) and asking for explanations of potential conflicts of interest – especially because Robinhood’s largest market maker is high-frequency trading firm Citadel Securities, whose commonly-owned Citadel hedge fund was helping to prop up Melvin Capital Management’s large short position then under attack by the sub-Redditors. Warren didn’t miss the chance to add her umbrage at Robinhood’s industry-standard arbitration clause – long a target of hers. Warren’s letter is here.

On this outrage du jour, civil class-action complaints blossomed. Media reports count at least 30 class-action suits filed so far. CNBC says angered users are turning to the app DoNotPay (“the world’s first robot lawyer …sue anyone at the press of a button” – ) to automatically sign them up to sue their trading app (appropriate, I guess). At least one suit alleges Robinhood’s action was “a concerted effort to de-platform” it clients:

It turns out that Robinhood – along with many other online brokerage firms – had to suspend trading for a short breathing space in which to raise money to meet the capital requirements of their clearinghouse agreements. When trading volumes soar rapidly in highly volatile stocks, it increases the monetary risk exposure of all participants in the trading system, so they ask their counterparties to post additional capital to hedge that risk – and prevent liquidity crises that can bring the whole system down. Remember the capital calls on credit-default swaps during the financial crisis in Fall, 2008?

The SEC issued two statements that it is “closely monitoring the situation” and “is working closely with our regulatory partners, both across the government and at FINRA and other self-regulatory organizations, including the stock exchanges, to ensure that regulated entities uphold their obligations to protect investors and to identify and pursue potential wrongdoing.” The SEC statements are here and here.

Just a few days later, the brokerage self-regulatory-organization FINRA issued its “2021 Report on FINRA’s Examination and Risk Monitoring Program.” It combines two reports FINRA has issued every year for decades. But nestled mid-way through this year’s report is an “emerging risk”:

2020 witnessed a surge in new retail investors entering the markets via online brokers, as well as an increase in certain types of trading, including options. Some online broker-dealers’ apps—as well as those offered by other financial services and consumer-oriented businesses—include interactive and “gamelike” features, as well as related forms of advertising and marketing. Such features affect many aspects of how firms interact and communicate with customers, from initial advertisements through the opening of accounts, recommendations and the presentation of different investment choices.

While such features may improve customers’ access to firm systems and investment products, they may also result in increased risks to customers if not designed with the appropriate compliance considerations in mind. Firms must evaluate these features to determine whether they meet regulatory obligations ….

FINRA 2021 Report, here.

Prior Regulatory Actions

Robinhood already faced regulatory scrutiny. Massachusetts’ securities enforcers filed suit December 16, 2020, alleging:

“1) aggressive tactics to attract new, often inexperienced, investors; 2) failure to implement policies and procedures reasonably designed to prevent and respond to outages and disruptions on its trading platform; 3) use of strategies such as gamification to encourage and entice continuous and repetitive use of its trading applications; 4) failure to follow its own written supervisory procedures regarding the approval of options trading; and 5) breach of the fiduciary conduct standard….”

The Complaint is here.

Massachusetts regulators are among the most active of the states. Regulatory actions over (2) inadequate supervisory controls, (4) failure to follow them, and (5) breach of fiduciary duty are standard grist for the enforcement mill. What’s notable is the focus on Robinhood’s target audience (“new, often inexperienced investors” read “democratization of trading”) and on the app’s “gamification” of trading. The suit cites Robinhood’s “free stock” offer, cartoon confetti showers on completed trades, rewarding interactions with the app, push notifications and broad encouragement to follow “trending” stocks. Regulators allege a raft of customers with no prior investment experience using the app to execute anywhere from 15-92 trades per day. Robinhood is fighting the suit.

The next day, the SEC announced a settled action charging Robinhood with misrepresentations by omitting to disclose that payment-for-order-flow was its largest revenue source and failure to comply with its best-execution obligations. That Cease-and-Desist Order included a censure and a $65 million fine. In the Matter of Robinhood Financial, Rel. 34-90694 (Dec. 17, 2020), here. Indeed, in December 2019, Robinhood had settled a FINRA enforcement action over essentially the same conduct, paying a $1.25 million fine and agreeing to an independent consultant to fix the problem. The FINRA AWC is here.

What are the Issues?

So with Sen. Warren and others scolding the SEC (and the whole regulatory establishment) to “do your job,” just what are the issues that might outlast the outrage?

Best Execution is a broker’s duty (arising from the agent’s common-law duty of loyalty to its principal) to route an order for the best execution. FINRA Rules provide brokers

“shall use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. Among the factors that will be considered in determining whether a member has used “reasonable diligence” are:

(A) the character of the market for the security (e.g., price, volatility, relative liquidity, and pressure on available communications);

(B) the size and type of transaction;

(C) the number of markets checked;

(D) accessibility of the quotation; and

(E) the terms and conditions of the order which result in the transaction, as communicated to the member and persons associated with the member.”

FINRA R. 5310(a)(1), here. Both the FINRA AWC and SEC Order require Robinhood to comply with an independent monitor’s recommendation on these points and it since shifted away from using its own affiliate (which lead, in part, to these earlier enforcement actions). So while best-execution will remain a concern – especially during peak volume in highly volatile securities – it’s not likely to be long-haul issue.

Misleading Statements or omissions are a constant concern for any regulated entity with disclosure obligations. The tension between “sales and marketing” imperatives and brutal, complete honesty may be heightened by the very nature of the app’s customer interface (including a phone app’s inherent limitations on the effectiveness of disclosures) and some of the “gamification” concerns raised by Massachusetts.

Supervision & Compliance also are constant concerns for broker-dealers. See FINRA Rule 3110 (supervision), here.

FINRA Rule 3120 (supervisory controls), here.

But for online “app” broker-dealers – and especially one with Robinhood’s “democratization” mission – regulatory compliance on these subjects will require heightened supervision well-tailored to a fast-moving environment and customer demographics heavily canted toward the young and/or inexperienced and/or less-wealthy (among the standard metrics for “sophistication”). The nature of the customer interface, however, may provide opportunities for technological (algorithmic or AI) solutions to, for example, erect automatic firewalls or compliance hurdles to particular products and strategies.

Communications are at the heart of Robinhood’s recent troubles: The lack of adequate disclosures on best-execution and payment-for-order-flow in the initial actions, and insufficient messaging about the reasons for the recent trading suspensions. See FINRA Rule 2210 (requiring principal review and recordkeeping, especially for retail customer communications), here; FINRA Rule 2214 (review and disclosures around investment-analysis tools), here; FINRA Rule 2220 (options), here.

Reg BI, KYC and Suitability represent perhaps the greatest challenges to Robinhood and others in its space. The SEC adopted Regulation Best Interest (“Reg. BI”) in June 2019, representing a compromise of sorts among competing interests (RIA’s vs BDs) in the aftermath of the Department of Labor’s “Fiduciary Rule” (struck down by the Courts). Reg. BI requires brokers to act in a retail customer’s best interest when recommending any securities transaction or investment strategy or making an account recommendation. 17 C.F.R. § 240.15l-1; Adopting Release, No. 34-86031 (June 5, 2019), here. It entails four component obligations:

  • Disclosure Obligation: provide certain required disclosure before or at the time of the recommendation, about the recommendation and the relationship between you and your retail customer;
  • Care Obligation: exercise reasonable diligence, care, and skill in making the recommendation;
  • Conflict of Interest Obligation: establish, maintain, and enforce written policies and procedures reasonably designed to address conflicts of interest; and
  • Compliance Obligation: establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.

SEC Small Entity Compliance Guide, here.

The Disclosure Obligation includes Form CRS containing prescribed disclosures about the broker’s relationship with the customer, including fees, costs, conflicts of interest, and standards of conduct, among others. See Form CRS, here. These are among the disclosures (or in that case, omissions) that led to the prior SEC action against Robinhood.

The Care Obligation includes obligations of care and diligence on (a) understanding the security, how it behaves in various market conditions (“objective suitability”), (b) reasonably determining that it is suitable for the particular customer’s attributes, circumstances and desires (“subjective suitability”), and (c) that the amount of the transaction (or product exposure) is suitable for the customer (“quantitative suitability”). The Reg. BI care obligation implicates FINRA Know-Your-Customer (“KYC”) and suitability obligations. FINRA Rule 4512 requires brokers to keep a record of certain information about a customer’s financial circumstances, here. FINRA Rule 2310 sets out the “suitability” rule, here. FINRA Rule 2360 (options), here.

Actions or communications count as a “recommendation” when the facts and circumstances indicate they reasonably might be viewed as a “call to action” that is reasonably likely to influence a customer to act. So that’s the rub for trading apps that “gamify” the experience for the inexperienced. Social media experience suggests (at least to the Massachusetts AG) that rewarding trades with emoji and confetti shower graphics, or using algorithms or broad push notifications to prompt and promote certain interactions within the app, or broadly promoting “trending” stocks might reasonably be viewed as “calls to action” reasonably calculated to induce action by the target customer demographic.

The Conflict of Interest Obligation requires brokers to identify, understand, mitigate and disclose conflicts of interest. It is an important part of the Form CRS required disclosures. Robinhood’s payment-for-order-flow revenues from Citadel Securities and others is a central focus of Sen. Warren’s letter.

The Compliance Obligation requires firms to maintain and test policies and systems reasonably designed to ensure they fulfill their regulatory obligations.

Future Focus

FINRA issued an Investor Alert on the subject , urging caution on day-trading, options and the use of margin, among others.

“Independent social media platforms and some brokerage firms offer tools that analyze or aggregate information from social media sources to help investors make investment decisions. Depending on how it is presented, social sentiment information—particularly real-time discussion platforms and buy/sell indicators driven by social sentiment—can lead to emotionally-driven or impulsive investment decisions, which can be a risky way to approach investing. Learn more about Social Sentiment Investing Tools.”

Following the Crowd: Investing and Social Media (FINRA Jan. 29, 2021), here.

The greatest issues confronting regulators and those in the Robinhood space lie where traditional securities regulatory approaches intersect with the mass-market reach, relative anonymity, and intuitive, behavior-modifying attributes of social-media user-interfaces. Reporting on Treasury Secretary Yellen’s February 4 “Gamestop” meeting with financial-markets regulatory heads, the New York Times wrote: “The entire episode has caused Washington’s financial overseers to examine whether markets – in becoming both more democratized by technology and more subject to the whims of social media – have changed in ways that require new attention and potentially different regulation.” Yellen and Regulators Met Amid GameStop Frenzy to Discuss Market Volatility, New York Times (Feb. 4, 2021).

Financial-market regulators have dealt with such changes before, of course. It took some time, however, to reach consensus on how best to apply foundational regulatory principles (and rules) to newly-arrived technologies, such as e-mail, social media, and high-frequency trading. The regulatory challenge will be to apply those existing rules to new trading platforms in ways that provide investor-protection without inhibiting market access. On the social media side, regulators will need to reconsider existing market-manipulation principles, and even related antitrust or trade regulation considerations like group boycotting, to determine when free speech crosses the line to manipulation.

Robinhood’s Immediate Response

Robinhood responded quickly with a series of tweets and blogs explaining the suspension and the reasons for it, later lifting it after successful capital raises. The company took out a full-page ad in the New York Times. And we all will watch Robinhood’s Super Bowl commercials.

Robinhood has hired teams of lawyers including a past SEC Director of Enforcement, and is disputing the Massachusetts regulatory action. But it may be a long time before Robinhood finds its way out of Sherwood Forest.

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