Robinhood has been in the news a lot again lately, and that news isn’t terribly favorable. Given that we represent investors, not firms, we fielded a lot of calls about Robinhood’s potential responsibility related to folks’ losses related to GameStop, AMC, Nokia, and Blackberry. To our great surprise, we concluded that, based on what we know now, we don’t see a viable claim.
We have learned, however, of a strategy Robinhood has been using to drum up business that might well expose it to liability. While it touts itself as a platform simply designed to fill customer orders, it appears that it has actually been making recommendations and may be exposed to liability when those recommendations are not in the customer’s best interest.
What’s the Big Deal About Recommendations?
Up until June of 2020, brokerage firms had an obligation to ensure that recommendations made to customers regarding particular securities transactions were suitable for those customers. The Financial Industry Regulatory Authority (“FINRA”) had a rule on the subject: Rule 2111, which required that a firm or broker have a reasonable basis to believe that a recommended transaction or strategy involving securities was suitable for the customer, based on information obtained through the firm or broker’s reasonable diligence to determine the customer’s investment profile.
What does that mean in plain English?
Brokers were required to make recommendations that were consistent with the customer’s investment objective, risk tolerance, tax status, experience, and other customer-specific details. Recommending a risky stock for a retired person living on a fixed income who said they didn’t want any avoidable risk in their portfolio was unsuitable. A loss related to the purchase of that risky stock could be recoverable.
Brokers and customers worked under a version of the suitability rule for decades. The parameters of what was, or was not, suitable was well understood (if often debated in arbitration hearings brought by aggrieved customers). But there’s a new sheriff in town: Regulation Best Interest (“Reg. BI”). The SEC imposed Reg BI on June 30, 2020.
The rule is simply too new at this point to have any understanding of how arbitration panels will apply it when customers complain. FINRA and the SEC have both gone on record, however, as stating that Reg BI is intended to be more broad than was the old suitability rule.
Under Reg BI, not only must an investment recommendation be suitable for a customer, but it must actually be in the customer’s best interest. Thus, if there are two investments, both of which could be considered suitable, the broker’s analysis must go further and they must recommend the one that is objectively better for the client.
Consider a very basic (and simplified) example: say that two investment products were identical in every regard save one, since one had an internal cost charge of 2% and the other had one of .5%. The product with the higher charge cannot perform as well as the other for the simple fact of the drag that charge applies to the performance. Under that (highly unlikely) scenario, a broker would be said to violate Reg BI in recommending the more expensive product since it would not be in the client’s best interest.
Online Brokers and Recommendations
Brokers are held liable when their recommendations are made in violation of the applicable rule. What happens, then, for an online broker when a customer logs on, picks a security, and asks that a transaction be made? Where is the recommendation there?
The question of whether online brokers were making recommendations to clients is not a new one. The principal regulator, the National Association of Securities Dealers (“NASD,” the predecessor to FINRA), addressed the subject in Notice To Members 01-23 (“NTM 01-23”). For those not familiar with the naming convention for these notices, please know that this one was the 23rd notice issued in 2001. That’s right – this Notice came out nearly twenty years ago.
NASD was addressing the then-new proliferation of online brokerage firms and assessing when those firms could be deemed to be making recommendations when the stated idea of online brokerage portals was to serve as simple “order takers,” not full-service brokers. NASD stated that the NTM was meant to address two questions: (1) whether the suitability rule should apply to online brokerage firms at all; and, (2) what sorts of online activity would constitute “recommendations” for purposes of the rule.
The NASD addressed the first question quickly and without ambiguity: the suitability rule applied to recommendations, whether they were made electronically or not. The answer to the second question was, however, more nuanced and NASD explicitly refused to craft a bright-line test for whether certain conduct would be considered a “recommendation.” Rather, NASD stated that all of the “relevant facts and circumstances” would be taken into consideration when determining whether a particular communication constituted a recommendation or not. NASD stated:
The determination of whether a “recommendation” has been made, moreover, is an objective rather than a subjective inquiry. An important factor in this regard is whether – given its content, context, and manner of presentation – a particular communication from a broker/dealer to a customer reasonably would be viewed as a “call to action,” or suggestion that the customer engage in a securities transaction.
Continuing, NASD told its members that the more individually tailored a communication was (be it to a specific customer or group of customers, regarding a security or group of securities), the more likely it was the communication would be deemed a “recommendation.”
In an effort to promote better understanding of its intent, NASD then provided a series of examples of conduct that would, or would not, be deemed a recommendation. Simply making research reports available was not considered a recommendation, where allowing an investor to request search results tailored to their particular interests, investment objectives, and risk tolerances was deemed a recommendation.
Of particular interest is NASD’s description of the following as an example of a recommendation: “A member sends a customer-specific electronic communication (e.g. an e-mail or pop-up screen) to a targeted customer or targeted group of customers encouraging the particular customer(s) to purchase a security.” Thus, if a firm sought out a client to suggest the client consider a security, that would be deemed a recommendation.
NASD described another example, where a firm was actively seeking particular clients: “A member uses data-mining technology (the electronic collection of information on Web Site users) to analyze a customer’s financial or online activity – whether or not known by the customer – and then, based on those observations, sends (or “pushes”) specific investment suggestions that the customer purchase or sell a security.” Thus, should a firm look at its customers’ trading habits and use that information to send targeted suggestions that those customers consider certain securities, the suggestions would be deemed “recommendations” subject to the suitability rule (and now Reg BI).
Robinhood is obviously an online-only brokerage firm. But is it making recommendations? It appears that its strategies to drum up business fall within the sorts of conduct NASD stated would be considered a “recommendation.”
Robinhood has allegedly been engaging in data mining and sending targeted communications to customers who aren’t trading enough, in an effort to promote trading. Why would it do that? While Robinhood famously promotes its “commission-free” trades for customers, it is well compensated when its customers trade. How? It sells its customers’ orders to market-makers for execution. The practice is commonly called “payment for order flow.” The more orders Robinhood customers generate, the more money the firm makes. It should therefore come as no surprise that Robinhood has a vested interest in encouraging its customers to trade.
Robinhood’s efforts to encourage trading utilize a variety of methods. A list of “biggest movers” available at login is equally available to all customers. The provision of such a list is unlikely to be deemed a recommendation since it is made equally to all customers, much like a billboard on a highway. But it has recently come to light that Robinhood is engaging in data mining to encourage its customers who aren’t trading (enough) to trade (more).
In a complaint filed late last year, the Massachusetts Securities Division alleged that at least one customer who hadn’t yet traded received a push notification from Robinhood stating “Top Movers; Choosing stocks is hard. [flexing bicep emoji] Get started by checking which stock prices are changing the most.”
The click-through took the customer to Robinhood’s top movers list. In a similar vein, Robinhood allegedly sent another push notification that read “Popular Stocks: Can’t decide which stocks to buy? [thinking emoji] Check out the most popular stocks on Robinhood.” The click-through was directed to the Robinhood 100 Most Popular List.
Robinhood’s push notifications are undoubtedly calls to action targeting select customers. As such, they are exactly the sorts of communications NASD said in 2001 would be considered recommendations. Thus, those communications could (and should) be deemed recommendations of the stocks found on the lists presented when customers follow the click-through links. What’ the problem, then? It appears that Robinhood engages in absolutely no suitability analysis whatsoever when making the suggestions.
Regardless of a customer’s stated risk tolerance or investment objective, Robinhood pushes them to a list of securities identified simply by the volume of trading in those particular securities. This is the very definition of a suitability rule / Reg BI violation. Suggesting stocks based solely on the volume of trading for those stocks cannot under any circumstances be deemed suitable or in a client’s best interests.
What can you do?
If you received a push notification from Robinhood, recommending you consider trading one of its “biggest movers” or “top movers,” and you lost money in the stock market on that trade, you may be able to recover if that security was, in fact, unsuitable for you.
If you lost $25,000 or more on stocks you purchased in response to a Robinhood push notifications, please reach out to us to discuss your experience and we’ll see whether we’ll be able to offer our assistance. There’s no cost for that initial conversation. You’re welcome to use our contact form, or toll-free number – (866) 932 1295.
Hugh Berkson is a Securities Attorney with McCarthy, Lebit, Crystal & Liffman, Co. LPA. Hugh is rated AV® Preeminent™ by Martindale-Hubbell®.
He obtained a business degree in Finance from the University of Texas at Austin in 1989, and is a 1994 graduate of Case Western Reserve University School of Law, where he was a member of the Order of the Barristers and received both the American Jurisprudence Award, (National Mock Trial) in 1993 and the Jonathan M. Ault Mock Trial Prize for 1993-1994.