BOSTON (CN) — Robinhood Financial, the high-flying stock-trading app that’s hugely popular among millennials, was hit with a consumer-protection suit Wednesday by the state of Massachusetts.
Accusing the company of building its customer base even though it knew its infrastructure couldn’t keep up with it, the complaint notes that Robinhood suffered at least 70 system outages this year — including one that lasted all day on March 2 when the Dow Jones Industrial Average had its largest point gain in history.
The complaint notes that Robinhood offers commission-free trades and uses inappropriate gimmicks to encourage its customers to trade constantly without any regard for whether the trades are suitable for them.
In one case, “Robinhood allowed a customer with no investment experience to make more than 12,700 trades in just over six months,” the complaint says.
The suit by the Massachusetts Secretary of State’s Office is legally significant meanwhile because it’s based in part on a new state law that requires stockbrokers to act as fiduciaries.
Indeed the fiduciary-based enforcement action is “the first that we’re aware of in the country,” said Deb O’Malley, a spokeswoman for the secretary’s office.
Compared with fiduciary duty, current rules from the Securities and Exchange Commission require brokers to act in customers’ “best interest,” explained Charles Whitehead, a professor of securities law at Cornell Law School.
Whitehead believes the Massachusetts enforcement action means that national and regional brokers might have to start changing the way they do business or else pull out of the Massachusetts market.
“It’s very hard for a broker to be a fiduciary,” Whitehead said in an interview. “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.
“Any broker — online or not — who’s doing business in Massachusetts has to be aware that the new standard is being enforced,” he added, and “of course they’ll be worried. Some might make a decision not to do business there.”
At one point the Obama administration attempted to impose a fiduciary standard on certain brokers, but that rule was struck down in 2018 by the Fifth Circuit.
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.
The app-based company makes money through interest on accounts, margin lending, premium products and the controversial practice of payments for order flow. It was valued at $5.6 billion in a 2018 funding round.
“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.
The Massachusetts complaint depicts Robinhood as using “gamification” to hook its young consumers into trading constantly, showing colorful confetti raining down on the screen after every trade and rewarding customers for endlessly tapping on a fake debit card. The company frequently approved people for complex options trading even though they had little or no investment experience, it said.
Robinhood also “relentlessly bombards” customers with gimmicks such as lists of most popular or most traded stocks with no effort to determine whether the stocks are suitable for them, the complaint stated.
“This is no different from a broker-dealer agent handing a list of securities to a customer, pretending to be surprised when the customer purchases securities from that list, and then proclaiming that he made no recommendations to the customer,” the complaint claims.
Robinhood also allegedly promotes free stock to new customers that it says could include shares of Microsoft or Apple, despite the low probability of a customer actually receiving such shares.
“Robinhood is over the line and an outlier by anyone’s standards,” according to Whitehead.
O’Malley refused to say if her office would go after any more traditional brokers under the new standard, citing a policy of not commenting on pending investigations.
Curtis thinks a possible defense in the case is that the Massachusetts fiduciary rule is preempted by federal securities laws, a topic that has been discussed in academia and legal seminars.
“This case will be an important test of state fiduciary rules, and Robinhood has the resources and incentives to dig in,” Curtis said. “If they argue that the Massachusetts rules are preempted by federal law, they will have the backing of the brokerage industry. I don’t expect this to be settled anytime soon.”
On the other hand, if Massachusetts wins, it could be another example of “states taking the lead in reforming Wall Street,” said Whitehead.
He notes that some years ago a handful of states took on the practice of brokers’ research analysts publicly pumping stocks of business clients while privately disparaging them to their internal traders, and this led to reforms at the national level.
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