Robinhood, âa premier broker-dealer that offers commission-free transactions to retail clients through its website and mobile apps,â recently agreed to pay a record amount of $ 70 million – consisting of a $ 57 million fine and over $ 12.5 million in restitution to 2,832 clients – to address a myriad of FINRA rule violations dating back to 2016. Letter of acceptance, waiver and consent n Â° 2020066971201 (“AWC”) reads like a final exam in a course on corporate compliance and securities regulation, there are two key takeaways that deserve special attention. First, excessive reliance on technology without sufficient warranties or personal verification may result in substantial liability. Second, making claims about new, non-traditional products offered directly to customers may be misleading or deceptive and in violation of FINRA Rules 3110 and 2010, if FINRA determines that communications are not sufficiently disclosed.
Excessive reliance on technology
As a FinTech – and very successful – company, it’s no surprise that Robinhood’s operations rely heavily on a variety of different technologies to deliver services to its clients, including proprietary software and client analytics algorithms. . This reliance on technology has allowed Robinhood to grow rapidly without having to make the same expensive investments in personnel, real estate, or other costs that have traditionally accompanied the growth of other financial services companies. However, this rapid, technology-driven growth was not without its risks; and as AWC makes clear, many of these risks have translated into real problems for Robinhood and its customers.
First, Robinhood relied on a nearly fully automated system to approve clients for the options trading program offered by the company. These âoptions account approval botsâ were algorithms designed to determine whether clients had the level of experience and risk tolerance required for options trading to be right for them. However, âapproval botsâ had obvious flaws and could be easily fooled. For example, a client may apply based on certain information and be denied options trading, then apply a few minutes later with different and inconsistent information and be approved for a certain level of options trading. To make matters worse, for years Robinhood’s human review of these apps only covered 20 apps per week. More recently, Robinhood has increased the human review to 500 requests per week, but these reviews are limited to determining whether the “approval bots” performed correctly and do not independently assess whether applicants should qualify for the test. option trading. More generally, Robinhood did not have any employees whose main professional responsibilities were related to customer identification; and during a period of time when a single director of the company approved more than half of the 5.5 million new accounts receivable that were opened.
Second, Robinhood failed to adequately oversee its technology infrastructure and ensure that it was sufficiently prepared for its substantial growth, extreme market conditions, and potential outages. Robinhood has experienced numerous outages, one of which was caused by a single overloaded system that had a domino effect on the rest of the Robinhood platform. Less than a week later, Robinhood suffered another outage when an update to its systems was implemented before it was properly tested; and the update caused the order entry system to shut down for approximately 45 minutes. A major problem with Robinhood’s setup was that it was outsourcing the operation of its website and mobile apps to its parent company without adequate oversight. This lack of oversight was particularly problematic because Robinhood had written procedures in place that required people from Robinhood to oversee these technology functions; but no one was ultimately responsible for their implementation – and no one ever did.
Third, Robinhood’s systems and its trading application – its key interface with many of its clients – have been poorly designed in an attempt to prevent clients from trading on margin when they have chosen not to participate in margin trading. or that they only had a more limited type of account which should have prevented them from using margin under any circumstances. This technological failure has allowed more than 818,000 clients to trade using margin when their account type or individual choice should have prevented this from happening. As the AWC specifically notes, this included the tragic case of a 20-year-old client who committed suicide after believing he lost over $ 700,000 using margin in a trade despite choosing to deactivate the margin on his account. Robinhood recently settled a civil lawsuit filed by the family of the young man who lost his life.
Fourth, Robinhood’s technology has also failed in several ways to display accurate information to its customers. In one instance, Robinhood displayed inaccurate cash balances and âpurchasing powerâ calculations for a certain subset of its customers. In another instance, Robinhood displayed incorrect historical performance figures to clients because they did not account for cash dividends and other cash movements and transactions. In a third example, Robinhood systems displayed incorrect information to customers for over four years because Robinhood failed to timely process corporate transactions such as stock splits, dividend payments, and miscellaneous merger and acquisition activities. Robinhood’s inability to put in place appropriate systems to monitor and verify the information it communicated to its clients ultimately impacted millions of its clients and was a major component of FINRA’s rule violations under – adjacent to the AWC.
Added to all of the issues described above was the fact that Robinhood’s business continuity plan was not adequately designed to deal with technology emergencies. Rather than taking into account all types of contingencies that could impact Robinhood’s operations, the business continuity plan only meaningfully addressed potential physical disasters that prevented the use of Robinhood’s offices. Another fundamental problem was that Robinhood based its plan on a model for âsmall introductory businessesâ, despite the fact that it had become a much larger and more sophisticated operation than the model plan it envisioned. In 2015, Robinhood had less than 500,000 customers. Today, although it has only 770 registered representatives and 6 branches, it has 31 million customers.
âCommission-Free Investmentâ, âFree Stock Incentivesâ and Other Problematic Promotions
While Robinhood’s technology failures were significant and involved many different aspects of its operations, FINRA also cited Robinhood for various misleading claims it made in connection with promotions, marketing and other communications with clients. and potential customers.
In a naturally popular and eye-catching promotion, Robinhood sought to attract new customers by offering free actions to entice new customers to open accounts. While it was true that Robinhood would give free shares to members of the public who opened accounts as part of the promotion, Robinhood failed to disclose that there was a 98% chance that the free shares would only have valued at $ 2.50 to $ 10.00. Instead, the promotional material deceptively touted the possibility of new customers receiving shares in companies that had a significantly higher value, like Apple.
In a second episode of marketing efforts gone awry, Robinhood was cited for the much-criticized abortive launch of its “Checking & Savings” program. Harnessing the power of viral marketing and its large existing customer base, Robinhood saturated social media and customer inboxes with promotional material for a new checks and savings product in December 2018. Although the product did have Closed just one day after its announcement, the marketing campaign was so successful that it resulted in nearly a million customers signing up for early access to the product. However, the program’s promotional material had a number of critical flaws, including: (1) touting SIPC coverage for accounts despite not having that coverage; (2) mistakenly equating the âChecking & Savingsâ mark with a bank deposit account; and (3) offering an apparently guaranteed interest rate of 3%, but which was in effect a floating rate that depended on other benchmarks.
Finally, FINRA took issue with Robinhood’s advertising that it had âcommission-free investingâ without also adequately disclosing other fees and expenses that might apply to the allegedly âcommission-freeâ trading activity. “. Robinhood also erred in advertising its âsplit stock investingâ capabilities to potential clients, as the split stock investing program had many other terms and conditions that were not prominently disclosed in as part of promotional material.
The record-breaking nature of FINRA’s settlement with Robinhood may have made headlines, but the real story as we see it is twofold.
First, while the use of emerging technologies, increasing connectivity with customers, and offering new and interesting financial products can help companies gain attention and gain market share, there are risks. substantial to embark on such a technology-dependent path. As the Robinhood example clearly shows, it is essential to mitigate these risks by ensuring that these systems perform as advertised, are reliable, are properly monitored and supervised, and that there are contingency measures in place. to deal with potential problems quickly and accurately.
Second, whether you offer traditional products and services to customers and prospects, or strive to offer the latest and greatest financial products, your information about your offerings should be complete, clear, and give a complete picture of all associated risks. Whether large or small, established or emerging, every financial services company should heed Robinhood’s warning, especially in light of the new standard of care set by Regulation Best interest.