BOSTON (CN) — The Massachusetts Supreme Court appeared amenable Wednesday to imposing strict new requirements on stockbrokers that could dramatically change the way the industry operates, or at least cause numerous brokerages to abandon doing business in the Bay State.
At issue is a rule adopted by state regulators that says broker-dealers have to act as fiduciaries if they recommend a trade. Traditionally only full-fledged investment advisors have to act as fiduciaries, whereas ordinary stockbrokers are held to the lower standard of acting in their customers’ best interest.
“It’s very hard for a broker to be a fiduciary,” said Charles Whitehead, a professor of securities law at Cornell Law School. “A broker is a salesman. A fiduciary is like a doctor. Before doctors make a recommendation, they’ll give you a full check-up and find out everything that’s going on with you. So if I’m trying to sell you a stock and I’m a fiduciary, I’d need to know what’s in your bank account, what stocks you have with other brokers, and so on. It’s a much more difficult standard.”
If the Massachusetts rule is upheld, brokers across the country will be very worried and “some might make a decision not to do business there,” Whitehead said.
Roughly 95% of individual investors currently use broker-dealers (a system where they pay per transaction), and only 5% have advisory accounts with fiduciary responsibilities that typically charge a recurring fee based on the size of the account.
Because such accounts generally have large minimum balances, forcing ordinary stockbrokers to act as fiduciaries could price most retail investors out of the market, the U.S. Chamber of Commerce warned in an amicus brief.
Massachusetts regulators adopted the new rule in an effort to crack down on Robinhood Financial, a high-flying stock-trading app popular among millennials that they say treats investing as a video game and “relentlessly bombards” customers with irresponsible gimmicks, such as images of raining confetti to promote stock trades, without any regard to whether they’re appropriate.
“Robinhood allowed a customer with no investment experience to make more than 12,700 trades in just over six months,” and it frequently approves people for complex options trading, even though they have little or no investment experience, the state claimed in its complaint.
The company “is over the line and an outlier by anyone’s standards,” Whitehead argued.
Robinhood was founded in 2014 by two former Stanford roommates, Baiju Bhatt and Vlad Tenev, and grew to 13 million customers by 2020. Unlike many brokerages that seek an older and more affluent clientele, the median age of Robinhood’s customers is 31.
Robinhood is no stranger to controversy. In 2020 it paid $65 million to settle SEC claims that it profited by not giving customers the best prices on trades, and in 2021 it paid $57 million to FINRA for outages and misleading communications. In 2022 its cryptocurrency division was fined $30 million by New York regulators for violating money-laundering and cybersecurity regulations.
A lower court threw out the new Massachusetts rule, finding that the secretary of the commonwealth, while able to ban “unethical” and “dishonest” conduct by brokers, went too far in saying that failing to act as a fiduciary when recommending trades is unethical and dishonest. “Unethical and dishonest have to have some meaning beyond the Secretary’s say-so,” argued Robinhood’s lawyer, Amy Saharia of Williams & Connolly in Washington.
But Justice Dalila Wendlandt called this a “sky-is-falling” argument. “It’s not like the secretary is saying that wearing blue is unethical," Wendlandt noted. "The specific question is whether this definition is unreasonable.”
Saharia said the definition was unreasonable because it was contrary to SEC rules and the common law and no other state had adopted it.
“So the secretary is limited to the least common denominator?” Wendlandt challenged her. “The secretary can’t be first? Someone else always has to take the lead?”
Justice Serge Georges jumped on this point. “How is leading from the front inconsistent with a broad mandate from the legislature to go out and protect consumers?” he asked. He noted that the Dodd-Frank Act gave the SEC a mandate to protect choice within the industry (i.e., brokers vs. investment advisers) but the state securities law focuses solely on consumer protection, not industry choice.
Justice David Lowy said “the only question is whether or not the language of [the state law] delegates the power to provide these definitions.” Georges read the delegation language out loud, and Lowy reacted, “My goodness, that was a big delegation!” He said the secretary was given “broad powers to advance the public interest.”
Saharia argued that the secretary departed from the tradition of defining terms in accordance with industry standards, but Wendlandt asked: “Wasn’t whole purpose of Dodd-Frank that the industry wasn’t doing a good job and we need to up the standards?”
“The law doesn’t have to be frozen as what it was a century ago,” Wendlandt added.
Still, the justices posed some sharp questions of Assistant Attorney General Phoebe Fischer-Groban when she defended the rule, including whether it was preempted as a result of the SEC’s having considered a similar restriction before rejecting it. Fischer-Groban said, no, because the rule was consistent with what could have been allowed under Dodd-Frank.
Having a conflict of interest, such as when brokers recommend a trade simply because it would help them to win a sales contest, could reasonably be considered unethical, she said. The Massachusetts fiduciary rule requires brokers to avoid, eliminate or mitigate such conflicts, whereas the SEC merely requires brokers to disclose them.
“Disclosures aren’t enough for retail investors,” Fischer-Groban argued. “They don’t understand them.”
If the court upholds the rule, the result could be seen as one questionable company — Robinhood — spoiling the party for a whole industry by taking things too far.
“Tech companies often believe that because they are innovative they operate outside existing rules, but just like Uber has to grapple with taxi and labor laws from a different era, Robinhood has to navigate the rules that apply to brokers,” said Quinn Curtis, who teaches securities and venture capital at the University of Virginia School of Law.
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