Robinhood’s Historic $70 Million Fine: What Investors Need to Know
Robinhood Financial has built a multibillion-dollar brand on the promise to “democratize” and “demystify” investing. While striving to help people succeed is an admirable idea, recent events have suggested the reality of the situation is quite different.
On June 30, 2021, FINRA, the organization that regulates the brokerage industry, levied a record-setting financial penalty against the company. The settlement is the biggest in history and included a fine of $57 million plus an order to pay another $12.6 million in restitution to thousands of customers.
In the 123-page settlement agreement, regulators further concluded that Robinhood inflicted harm on millions of its customers.
The Impact of Robinhood’s Historic Settlement
What’s dramatic here is that given Robinhood’s 31 million customers, the sheer number of people impacted is very high. While approximately 2,800 people will receive reimbursement from the FINRA settlement, there may be far more affected somehow.
More importantly, this Robinhood situation teaches all investors not to take marketing messages at face value. This article will summarize the report’s findings so you can educate yourself on the issues surrounding this case.
History of Providing False and Misleading Information
Robinhood’s self-described mission is to “demystify finance for all” and make investing “understandable for newcomers.” FINRA, however, found that the firm instead communicated false and misleading information to its customers on several fronts.
Many of these communication issues focused on margin trading. If you’re not familiar with the term, margin trading means using funds borrowed from your broker to buy investments.
FINRA pointed out several issues around Robinhood’s communication about margin:
Margin Trading Enabled for Cash Accounts
The firm falsely told Robinhood Instant customers that they had to upgrade to another product, Robinhood Gold, to use margin. However, the Instant product apparently enabled margin for many customers. So these customers could accidentally create a trade that would incur a margin loan without being aware of it.
That’s very different from other brokers, where the system would automatically prevent a cash account from making a trade that exceeded the cash balance. Instead, you would have to fill out an application and await approval to convert a cash account to a margin account. The extra step is required because margin involves significantly more risk than trading in a cash account.
Option to Disable Margin Didn’t Work as Promised
Then, FINRA found Robinood’s platform also told Gold account customers they could disable margin when the margin capability was still active and in use.
Display of Inaccurate Cash Balances
Robinhood’s system displayed extremely inaccurate cash balances at times, in some cases showing people large negative balances. This issue sadly made headlines when a twenty-year-old committed suicide when the Robinhood platform erroneously showed that he had a $700,000 negative balance, which was not valid.
Erroneous Margin Calls and Warnings
Additionally, the report detailed how Robinhood issued incorrect margin calls to customers or issued warnings that they were at risk of a margin call when they were not. These invalid messages may have prompted people to sell investments or liquidate accounts when they were not required to do so.
Along with providing false or misleading information about margin accounts, FINRA also found issues surrounding options communications.
Providing False Information about Option Risks
The report went on to say that Robinhood provided false information about the risks of options trading. The FINRA report cited one instance where Robinhood materials stated an investor could never lose more than the premium paid to enter a specific type of option spread. In reality, there was a significant risk of losing more. And FINRA found many instances where Robinhood customers did indeed incur much higher losses than the premium paid to enter the trade.
That’s just one part of the settlement related to communications.
Let’s move on to the next part of the report.
Failure to Exercise Due Diligence on Options Accounts
Options trading involves significant risk, so only those customers who can understand and afford to take on that risk are ordinarily eligible for this investment. If you want to trade options, you must fill out an application and provide information about your finances, knowledge, experience level and risk tolerance. Then the brokerage firm must determine if you are fit to take on this additional risk.
Although the firm’s written procedures assigned this job to staff registered to handle this responsibility, in reality, Robinhood allowed fully automated “option approval bots” to make these decisions. This automated system apparently suffered from a number of serious flaws. As a result, many people were allowed to trade options that likely didn’t have the experience, financial capacity or risk tolerance to do so.
Here are more details on FINRA’s findings in this area:
- These automated bots were programmed to approve options trading that a human supervisor would have likely denied. For example, customers under age 21 who reported having several years of options trading experience were approved in many instances.
- Also, customers who reported themselves as having low risk tolerance were approved for options trading.
- Customers could reapply within minutes, change their answers, and go from being denied to being approved.
FINRA found that due to these faulty bot programs, thousands of customers who didn’t meet the firm’s criteria for options trading were nonetheless approved.
Options trading can result in fast and significant losses. These policies were there to protect people from risks they didn’t have the experience or knowledge to understand. By not following its own rules, Robhinood may have endangered many of its customers’ financial security.
Failure to Supervise Technology
The third area of FINRA’s findings is in the realm of technology. FINRA found that Robinhood failed to supervise technology critical to providing customers with core broker-dealer services.
Robinhood calls itself a FinTech firm, meaning it relies on technology to deliver core functions. So, for example, when you place an order to buy or sell a stock, you don’t call Robinhood and talk to a human representative. Instead, you place the order online using the Robinhood platform.
Apparently, Robinhood outsourced the operation and maintenance of its platform to its parent company, which is not a member of FINRA. Also, in the process, Robinhood did not provide the necessary oversight to this maintenance work.
The Robinhood platform experienced a series of outages and critical failures. These failures made it difficult for customers to sell or buy investments or access their accounts. These are considered critical brokerage services.
The most severe outage in March 2020 left all of Robinhood’s millions of customers unable to trade during periods of intense market volatility. These outages persisted even after two warnings from FINRA that the firm was not reasonably supervising its technology. As a result, FINRA ruled that Robinhood violated regulations in these instances.
Other Violations Found
In addition, FINRA identified other issues:
- Failure to create a business continuity plan that incorporated technology-related business disruptions. FINRA noted this as especially important since the firm could leave its millions of customers’ funds at risk due to issues with its online platform. Customers saw a preview of this risk in March 2020, when the inability to log on to Robinhood’s online platform prevented many from accessing their accounts.
- Failure to report customer complaints to FINRA. Broker-dealers are required to register certain customer complaints with FINRA. It was found that Robinhood failed to report tens of thousands of complaints, including ones that involved Robinhood providing false or misleading information or involving customers who suffered losses due to the firm’s outages and systems failures.
- Failure to have a reasonably designed customer identification program. Broker-dealers are responsible for screening account applications for potential fraud, such as the use of an incorrect social security number. Robinhood was found to have opened over 90,000 accounts that had been flagged for potential fraud or identity theft without further review.
- Failure to display complete market data information. FINRA requires all its members to display complete market data on its website and mobile applications. Robinhood failed that at times, violating that rule.
The Significant Impact of Robinhood’s Actions
Due to the sheer scale of Robinhood’s user base, many of these actions likely involved many customers. For example, FINRA found that over 800,000 customers were impacted by having incurred margin debt after “disabling” the Margin option in Robinhood Gold.
Margin trading is a high risk activity where people can lose significant money quickly. It can also cause intense distress, and its financial impact can last years or even decades.
The seriousness of Robinhood’s offenses can be seen in the tragic story of the 20-year-old that took his own life. That occurred, according to FINRA, after the individual had turned the Margin feature off in Robinhood Gold. According to FINRA, in a note found after his death:
“he expressed confusion as to how he could have used margin to purchase securities upon assignment of the short leg of an options spread because, he believed, he had not “turned on” margin in his account.”
The misinformation about options trades is estimated to have impacted numerous customers as well. In particular, one specific strategy—debit spreads—appeared to cause widespread losses among customers. According to the FINRA report, Robinhood falsely assured customers who had entered into these option spreads that they did not need to take any action to mitigate their risk when heading into option expiration dates. However, that was false, and many customers sustained significant losses as a result.
Get Educated and Know Your Rights
As noted, this situation is notable both for its size and its scale. Typically, you probably wouldn’t think of second-guessing a major financial services company to ensure what they are telling you is accurate. However, in this era of “grow fast and break things,” it is becoming clear that we as investors need to interact with care with these types of companies.
While Robinhood has since corrected many of these issues and is unlikely to repeat these same mistakes, it is a message to all of us to proactively defend our money and our future.