Dive Brief:

• The Financial Industry Regulatory Authority (FINRA) on Wednesday ordered Robinhood to pay nearly $70 million to settle allegations the company misled customers, approved ineligible traders for risky transaction types, and failed to adequately supervise technology that left customers locked out of the platform during high-demand periods.
• The penalty clears the deck for Robinhood to file for an initial public offering (IPO). A prospectus to that end debuted Thursday. Robinhood is targeting a valuation of $40 billion or more in the coming months, the Financial Times reported, citing anonymous sources. It will trade on Nasdaq under the symbol HOOD and sell as much as 35% of its offering to its customers.
• Robinhood isn’t out of the regulatory woods. The company is being investigated by several state and federal agencies, including the Justice Department's Antitrust Division and the Treasury Department's Office of Foreign Assets Control, Thursday's filing revealed. Robinhood has set aside $15 million to account for "probable losses" in connection with a New York Department of Financial Services probe into anti-money laundering and cybersecurity-related issues, the filing showed. The U.S. Attorney’s Office for the Northern District of California executed a search warrant to obtain CEO Vlad Tenev's mobile phone.

Dive Insight:

Wednesday's penalty — the largest FINRA has ever levied — breaks down to a $57 million fine and about $12.6 million in restitution to customers. More than $5 million of that total will go to customers who couldn’t trade during a string of outages — notably, in March 2020, when the Dow Jones Industrial Average saw its largest one-day gain in 11 years. The other $7 million will go to customers who suffered losses stemming from Robinhood’s misstatements, including inaccurate negative cash balances, FINRA said.

"Compliance with [the rules that govern the brokerage industry] is not optional and cannot be sacrificed for the sake of innovation or a willingness to ‘break things’ and fix them later," Jessica Hopper, the head of FINRA’s enforcement department, said in a statement Wednesday.

The regulator found that Robinhood, as early as September 2016, negligently communicated false and misleading information to its users, including whether customers could place trades on margin, how much cash was in customers’ accounts, how much buying power customers had, and the risk customers faced in certain options transactions.

Robinhood failed to disclose to 818,000 customers who had been approved for options trading that their activity could involve margin lending, which could lead to losses that dwarf the money invested, the regulator found, adding that, in some cases, Robinhood displayed negative cash balances that were double the actual deficits for customers who had selected margin to be "off."

Inaccurate balance display reportedly played a role in a 20-year-old day trader’s June 2020 suicide. Alex Kearns, believing he faced a negative balance of $730,000 and unable to reach Robinhood customer service overnight, left a note questioning how he could have used margin in his trades because he believed he had disabled it on his account, FINRA wrote Wednesday.

Kearns’s family sued Robinhood, claiming wrongful death. The case was settled in May for an undisclosed amount, The Wall Street Journal reported.

Approval by bot

Robinhood used "option account approval bots" — computer algorithms with limited human oversight — when deciding whether to allow customers to trade options, FINRA said. The regulator, in its settlement document Wednesday, cited one trader who said he was rejected for options trading upon denoting he had little investing experience and a low risk tolerance. Within minutes, he changed his risk appetite to "medium" and claimed he had three years of investing experience, and Robinhood approved him.

The company opened 90,000 new accounts between 2016 and 2018 despite warning signs of potential identity theft or fraud, the regulator said, including more than 100 accounts where there was a "high probability that the customer’s Social Security number belonged to a deceased person."

Robinhood said it has fixed its balance display inaccuracies and boosted its oversight of customers’ use of options by conducting monthly reviews to ensure clients meet eligibility rules.

"Robinhood has invested heavily in improving platform stability, enhancing our educational resources and building out our customer support and legal and compliance teams," spokesperson Jacqueline Ortiz Ramsay told Bloomberg and CNBC in an emailed statement. The company neither admitted nor denied wrongdoing but outlined in a blog post several improvements it has made, including tripling its customer support staff — to 2,700 employees — since March 2020.

Underestimated amount

​FINRA’s penalty comes in addition to a $65 million settlement Robinhood reached with the SEC in December over the company’s failure to disclose until 2018 that it sold its clients' orders to high-speed trading firms. That process —payment for order flow — accounted for 81% of the company's revenue in the first quarter of 2021, the Financial Times reported Thursday. Robinhood in 2019 also agreed to pay FINRA $1.5 million to resolve allegations that it didn’t take adequate steps to ensure it got the best prices for customer orders.

Wednesday’s penalty was expected — but underestimated. Robinhood disclosed in a February securities filing that it had set aside $26.6 million in 2020 toward a potential FINRA settlement. Such underestimation is not new. Reports had pegged the SEC’s $65 million settlement at $10 million months earlier.

The SEC, for its part, is reviewing January’s meme stock rally, in which Robinhood temporarily halted trading of some stocks, including that of the video-game chain GameStop, because of a drastic increase in collateral the stock market's central clearing hub, the Depository Trust & Clearing Corp. (DTCC), sought from the company. Robinhood leaned on its investors and shareholders, raising $3.4 billion to meet the DTCC’s demands, but it locked traders out of the action for roughly a week, spurring some 50 lawsuits, according to The New York Times.

Massachusetts’s top securities regulator wants to revoke the company’s registration there as a broker-dealer. State officials filed an administrative complaint in December, alleging the company uses "aggressive tactics to attract inexperienced investors" and "gamification strategies to manipulate customers" into frequent interaction with the app.

Wednesday’s FINRA complaint did not mention gamification, but Robinhood is keenly aware of that perception. The company in March retired its signature confetti animation, which appeared when users reached investing milestones. The display drew flak not only in the Massachusetts complaint but in a Senate hearing for then-nominee Gary Gensler to lead the SEC.

Exponential growth

Robinhood has grown exponentially despite its regulatory woes. The company's first-quarter revenue — $522 million — represents fourfold growth over a year earlier, the company's SEC filing Thursday showed. The number of funded accounts on the platform rose from 5.1 million at the end of 2019 to 12.5 million at the end of last year, then jumped to 18 million during the first quarter, when the GameStop rally was at its zenith. Users, however, transferred their assets out of Robinhood at nearly 10 times the average rate after the company's weeklong halt of trading in certain stocks, according to The Wall Street Journal.

Despite the boost in revenue, Robinhood reported a $1.4 billion loss for the first quarter — largely because of a $1.5 billion one-time charge it took over the emergency funds it raised to cover the DTCC's collateral demand.

Under Wednesday's settlement, Robinhood must hire a consultant to review its compliance systems within six months. Robinhood would then have another three months to institute recommendations.

Outage fallout

Some of the recommendations may aim to correct a system FINRA faulted for the spate of outages that plagued Robinhood in March 2020, preventing as many as 12.5 million account holders from trading.

Robinhood’s contingency plan in case of disruption applied only to a physical disturbance rather than a technological one, FINRA said. The regulator warned the company twice that it wasn’t properly managing its technology, but outages continued, it said.

"We’re fine with innovation, but innovation can’t be at the cost of creating compliance and supervision systems," Hopper told The Wall Street Journal.

One outage stemmed from an untested update to how Robinhood communicated with a trading venue that executed client orders, FINRA said, adding that senior executives knew disruptions threatened the company’s reputation and growth but failed to institute adequate supervision.

FINRA also faulted Robinhood for failing to report tens of thousands of written customer complaints that it was required to submit.

Reaction

Robert Frenchman, an attorney with Mukasey Frenchman & Sklaroff, told Reuters the settlement sends a clear message. "You can try to democratize investing and demystify finance, but you can’t cut corners," he told the wire service.

Sen. Elizabeth Warren, D-MA, in a tweet Wednesday, inferred simple penalties may not be enough for a company like Robinhood, which is so often the target of investigations. 

"Robinhood won't clean up its act with slap-on-the-wrist settlements," she wrote. "Our regulators need to show some backbone."

FINRA’s previous record penalty came in 2002, when it fined Credit Suisse $50 million over allegedly inflated commissions connected to IPOs, according to The Wall Street Journal.

As part of Wednesday's settlement, the regulator said it would launch a $30 million campaign to educate new investors.