Securities Regulation Daily Robinhood not so merry after $65 million penalty for misleading customers
Thursday, December 17, 2020

Robinhood not so merry after $65 million penalty for misleading customers

By Rodney F. Tonkovic, J.D.

Firm did not disclose that it took higher payments for order flow while giving customers inferior prices for their orders when compared to the competition.

Robinhood Financial, LLC, a retail brokerage, agreed to pay $65 million in penalties to settle SEC charges that it misled customers about its revenue sources. According to the Commission, the firm failed to disclose that its largest revenue source was payments from traders in exchange for sending them orders for execution. These high payments, however, came with poor terms for executing those orders, meaning that Robinhood failed to achieve best execution. These inferior trade prices ultimately deprived customers of over $34 million. In addition to the penalty, the firm agreed to a series of undertakings, including a review of its policies relating to customer communications and payments for order flow (In the Matter of Robinhood Financial, LLCRelease No. 33-10906, December 17, 2020).

Robinhood began offering retail brokerage accounts in 2015. From its launch through September 2018, by which time it had become one of the largest retail broker-dealers in the U.S., a primary selling point was that customers were not charged trading commissions. During most of this period, Robinhood's website featured a FAQ page, "How Robinhood Makes Money," that stated that the firm's revenue came from interest on the cash and securities in its accounts.

Initially, Robinhood disclosed that it received a "negligible" amount of revenue via payments for order flow, that is payments received in exchange for routing its customer orders to principal trading firms. Receipt of payment for order flow is permitted so long as is does not interfere with best execution and is disclosed. As time went on, Robinhood negotiated higher payments for order flow, which came with the trade-off of less price improvement for its customers.

In short, Robinhood knew that its customers' orders were executed at prices that were inferior to other brokers' prices. According to the Commission, the firm's almost three-year failure to benchmark its execution quality against its competitors in order to determine whether it was obtaining the best terms for its customers violated the duty of best execution. It addition, at some point in 2016 Robinhood removed any references to payments for order flow from its FAQ page despite this being its largest source of revenue; it also failed to retain records of these modifications. In addition, another FAQ page falsely claimed that Robinhood's execution quality matched or beat that of its competitors while, at the time, its execution quality was worse than that of any other large retail broker-dealer.

The Commission found that Robinhood's inferior trade prices in the aggregate deprived customers of $34.1 million in price improvement even with the savings from not paying a commission. "Robinhood provided misleading information to customers about the true costs of choosing to trade with the firm," said Stephanie Avakian, Director of the SEC’s Enforcement Division. "Brokerage firms cannot mislead customers about order execution quality." Erin E. Schneider, Director of the SEC’s San Francisco Regional Office, noted that many new companies are harnessing technology to provide alterative means for people to invest, but "innovation does not negate responsibility under the federal securities laws."

FINRA fine. In December 2019, Robinhood was fined $1.25 million by FINRA for best execution violations. FINRA found that the firm routed its non-directed equity orders to four broker-dealers, including its clearing broker, without reasonably considering the best execution factors set forth under FINRA rules. In addition to the fine, Robinhood agreed to retain an independent consultant to conduct a comprehensive review of the firm’s systems and procedures related to best execution. Since the SEC's claims are distinct from FINRA's, the order lists additional undertakings, including retaining a consultant to conduct a review of Robinhood's s supervisory, compliance, and other policies and procedures concerning its retail communications and disclosures.

Sanctions. The Commission found that Robinhood willfully violated Securities Act Sections 17(a)(2) and (3), which prohibit obtaining money through misrepresentations or omissions and engaging in fraud. The firm also violated Rule 17a-4's requirement that broker-dealers preserve originals of communications that relate to its business. In addition to a cease and desist order and censure, the firm will pay a civil money penalty in the amount of $65 million.

The release is No. 33-10906.

Companies: Robinhood Financial, LLC.

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