Dive Brief:

• Robinhood agreed to pay $65 million to settle charges from the Securities and Exchange Commission (SEC) that it failed to disclose until 2018 that it sold its clients' orders to high-speed trading firms, the agency said Thursday. Robinhood collected $466 million in payments from high-speed trading firms during the first three quarters of 2020, according to an analysis of its regulatory filings by Piper Sandler.
• The settlement comes one day after Massachusetts securities regulators filed a complaint against the company, citing its "aggressive tactics to attract inexperienced investors, its use of gamification strategies to manipulate customers, and its failure to prevent frequent outages and disruptions on its trading platform."
• The complaint marks the state’s first enforcement action under a fiduciary rule it passed this year that stipulates a broker-dealer has a duty to be loyal to its customers, in part by making recommendations that prioritize customers’ interests independent of those of other parties.

Dive Insight:

Robinhood's $65 million settlement dwarfs the $10 million estimate first attached to the SEC's case in September.

The regulator alleges customers lost $34 million from 2016 to 2019 by trading on Robinhood instead of through other brokers. Those losses — and the company’s alleged misstatements to customers — are reflected in the settlement value, The Wall Street Journal reported, citing an anonymous source.

Robinhood claimed on its website in in 2018, that its “execution quality and speed matches or beats what’s found at other major brokerages,” according to the SEC order.

Robinhood in 2014 removed its website’s references to payment for order flow, as the practice of selling orders to high-speed traders is called, the SEC said. The company also told its customer-service representatives not to mention payments from high-speed traders when investors asked about Robinhood’s sources of revenue, according to the regulator.

Payment for order flow can create a conflict of interest because it gives brokers an incentive to send orders to the highest bidder. 

"We recognize the responsibility that comes with having helped millions of investors make their first investments, and we’re committed to continuing to evolve Robinhood as we grow to meet our customers’ needs," Dan Gallagher, the company's chief legal officer, told The Wall Street Journal in a statement.

The SEC settlement requires Robinhood to hire, within 60 days, an independent consultant to review how Robinhood’s policies address payment for order flow and its duty to provide clients with best execution of orders.

The settlement isn't the first Robinhood has paid on allegations it wasn't getting its customers the best prices. The company agreed to pay $1.25 million last December to settle similar claims from the Financial Industry Regulatory Authority.

A 'game that you might be able to win'

With Wednesday's complaint, Massachusetts takes aim at a platform it says seeks "continuous and repeated engagement" by encouraging customers via email alerts to make trades, using in-app prompts to push customers toward higher-risk investment products, celebrating trades with digital confetti, and sending users messages adorned with emojis prompting them to buy additional shares.

Rather than portraying its business model as "serious investing with substantial risk," Robinhood is "presented as some sort of game that you might be able to win," William Galvin, the state’s secretary of the commonwealth, told The Wall Street Journal.

"They know that their investors are primarily younger. It’s because they think there are more unsophisticated investors among them," Galvin told Bloomberg. "They’ve exploited the current situation with the pandemic. They contributed to the frothiness of the market, bringing people in who don’t know much about it. They’re not responsible fiduciaries."

Robinhood said in a statement Wednesday that it disagrees with the allegations and plans to defend itself vigorously.

"Those who dismiss new and younger investors, who come from increasingly diverse backgrounds, as unsophisticated or unserious perpetuate the myth that investing is only for the wealthy," a spokeswoman for Robinhood told Bloomberg. "History is littered with startups criticized by the establishment that are now strong, longstanding businesses."

The median age of a Robinhood investor is 31, the company said.

Robinhood’s popularity ballooned to 13 million users this year, with 3 million joining in the first four months of 2020. And until September, the company was the top-valued U.S.-based consumer fintech.

But its reputation has taken its share of lumps over the past year. The company in December 2019 pulled its banking charter application with the Office of the Comptroller of the Currency (OCC), and in July indefinitely postponed a plan to launch its app in the U.K.

Robinhood also suffered a series of outages in March that left traders unable to access the platform on a day when the Dow Jones Industrial Average posted its greatest percentage gain since 2009. The mishap spawned a class-action lawsuit and a controversial offer by the company — a $75 goodwill credit that an attorney for the plaintiff saw as hush money. In Wednesday's complaint, Massachusetts cited as many as 70 disruptions or outages affecting the platform between January and November.

In October, according to Bloomberg, the dark web offered access to more than 10,000 email login credentials tied to Robinhood accounts.

And in June, a 20-year-old day trader who thought he had racked up a negative $730,000 cash balance mentioned the company in his suicide note.

It’s that demographic that Massachusetts is looking to protect with Wednesday’s complaint. The state said it counts 486,000 Robinhood accounts — worth $1.6 billion — among its residents.

But it’s not only the number of users that caught the state’s attention. It’s their activity level. State regulators allege Robinhood allowed one customer with no investment experience to make more than 12,700 trades in just over six months.

In the complaint, regulators also cite the rollout of Robinhood’s cash-management feature, which allowed customers to sign up on a waitlist for early access. Customers could move toward the top of the list by “tapping” a fake credit card in Robinhood’s app up to 1,000 times a day, the complaint said.

"Treating this like a game and luring young and inexperienced customers to make more and more trades is not only unethical, but also falls far short of the standards we require in Massachusetts," Galvin told the Financial Times.

Options trading and outages

Robinhood’s practices surrounding options trading have also drawn fire from the state. Options let traders pay relatively little for a big return if their bets prove correct. But losses can compound when bets are wrong. The state alleges Robinhood violated its own rules regarding options trading by approving unqualified customers to engage in the practice. About 68% of Massachusetts Robinhood customers approved for options trading identified as having limited or no investment experience.

The company spokeswoman refuted the state’s claims regarding options and outages.

"Over the past several months, we’ve worked diligently to ensure our systems scale and are available when people need them," she said. "We’ve also made significant improvements to our options offering, adding safeguards and enhanced educational materials."

State regulators also took issue with lists of popular trades Robinhood posts, saying they have the potential to influence what traders buy, but the company doesn’t provide "a suitability analysis" of those investments, which could lead to a conflict of interest.

"This is no different from a broker-dealer agent handing a list of securities to a customer, pretending to be surprised when the customer purchases securities from that list, and then proclaiming that he made no recommendations to the customer," the complaint said.

Robinhood denied the state’s allegations here, too. "Robinhood is a self-directed broker-dealer and we do not make investment recommendations," the company said.

Massachusetts regulators are seeking an administrative fine and aim to require Robinhood to enlist consultants to review the platform’s infrastructure with regard to outages. They also want Robinhood to tighten its policies allowing inexperienced users to engage in options trading.