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Robinhood has been a financial industry disruptor since it began in 2013. Some could argue this fintech startup is the one to thank for the abolishment of trading commissions and the rise in stock-trading mania of companies like GameStop and AMC.
However, not everything Robinhood has done in recent years has been considered good or even ethical, and it has resulted in some of the biggest fines ever imposed by trading regulators.
In 2021, Robinhood paid $70 million in a FINRA settlement due to multiple platform outages and allegedly misleading investors. In addition, the app froze trading for stocks like GameStop and AMC, forcing investors to hold on to their shares until market volatility slowed.
In this post, we'll go through what they were accused of and how that relates to you as an investor. We'll also briefly explore a few alternative trading platforms that you may wish to consider.
Robinhood Scandal – What Happened?
On June 30, 2021, Robinhood was penalized $70 million by the FINRA (Financial Industry Regulatory Authority), a government-authorized not-for-profit organization tasked with overseeing the securities industry.
The charges included $57 million in fines and an order to pay approximately $12.6 million in restitution, plus interest, to thousands of harmed customers.
The basis for the charge was related to what FINRA called “a series of failures that hurt Robinhood's clients.” This occurred just one month before the company was scheduled to hold its big initial public offering.
So what did Robinhood do wrong exactly that lead to such a substantial penalty?
1. Communicating False Information To Clients
Since at least September 2016, FINRA said there was evidence that Robinhood had “negligently communicated false and misleading information to its customers”.
These were for critical things that a brokerage must tell their clients, such as:
- Whether customers could place trades on margin
- How much cash was in customers’ accounts
- How much buying power or “negative buying power” customers had
- The risk of loss customers faced in certain options transactions
In particular, they highlighted the tragic death of twenty-year-old Alex Kearns, a young college student who took his own life after seeing he had a negative balance of $730,000 while trading options through Robinhood.
Kearn tried to reach out to Robinhood, but only received automated messages – including one stating that his first payment of $170,000 was due in a few days.
Sadly, the whole thing was a big mistake, and it wasn’t until shortly after his death that someone from Robinhood finally responded to Kearn suggesting the trade had been resolved and he didn't owe any money.
2. Approving Customers For Options Trading That Shouldn't Have Been
Trading options is an advanced investment strategy that’s not intended for the inexperienced.
However, rather than having a thorough review process in place, Robinhood instead relied on bots – computer algorithms – to decide who was eligible.
As FINRA discovered, this created a very inconsistent approval process. Thousands of people who had never traded a stock before were somehow approved without any warnings or red flags.
3. Lack Of Supervision Over Broker-Dealer Services
Finally, FINRA noted that between 2018 and late 2020 Robinhood experienced a series of outages and critical systems failures.
This was particularly troublesome on March 2 and 3, 2020, when news of the COVID pandemic started to cause historic market volatility.
As a result of these outages, many customers were able to access their accounts. Some people were locked out for days causing them to lose tens of thousands of dollars as their investments dropped in value.
This Wasn’t Robinhood's First Fine By Regulators
The 2021 FINRA penalty was not Robinhood's first run-in with financial regulators.
On Dec 17, 2020, the U.S. Securities Exchange Commission (SEC) announced that they had formally charged Robinhood $65 million for making “misleading statements and omissions in customer communications about its largest revenue source”.
To summarize the situation, Robinhood – who at the time advertised themselves as being fee-free – was actually providing their customers with inferior trade prices in order to cover excessive costs for what are known as “order flow rates”.
These are the payments between the trading firms (like Robinhood) and those that really carry out the trade execution.
In other words, Robinhood was actually charging customers a fee. It was just essentially hidden by baking it into the price of the stock and without the customers realizing it.
Why Do These Scandals Matter?
The Robinhood FINRA and SEC penalties are an important reminder to all financial services and professionals alike that they have a fiduciary responsibility to their clients.
Since the beginning, Robinhood's founders Vlad Tenev and Baiju Bhatt have said that the mission of this company is to democratize finance.
And in many ways, they've done just that by removing the barriers of commissions and streamlining the entire stock trading process. This is why the app has become so popular among younger investors.
However, this still must be done with responsibility and integrity. There must be qualifications in place to protect investors – especially the inexperienced ones – from mishandling tools that could ruin them financially and emotionally for life.
The FINRA fine serves as a reminder that higher standards need to be set.
Perhaps this can best be summed up by a blunt quote from Berkshire Hathaway's Charlie Munger.
In an interview with CNBC, Munger showed support for stronger regulation of Robinhood even calling it “a gambling parlor masquerading as a respectable business.”
Should You Still Use Robinhood After Its Scandals?
So after everything that’s happened, can clients trust Robinhood? Has the company learned its lesson?
Following the 2021 FINRA fine, Robinhood took measures to put new policies in place such as:
- New criteria and revised experience requirements for customers who want to engage in options trading
- More guidance for customers who want to get into options trading
- Updates to how the app displays buying power
- More educational materials on options trading
They even added the ability to get an immediate call back from a live agent and escalate critical issues – such as the situation that Kearns was facing.
These changes are great, but it seems Robinhood just can’t seem to stay out of trouble.
In January 2021, as Reddit users began instigating investors to buy shares of distressed companies like GameStop and AMC, Robinhood suddenly decided to prevent their clients from buying these stocks.
They claimed it was due to “market volatility” and staying in compliance with regulators. However, this angered their users who felt they were slighted by Robinhood.
Then, in August 2022, the New York State Department of Financial Services announced it has issued a $30 million penalty against Robinhood’s crypto division.
This time the allegation was that Robinhood Crypto’s anti-money laundering and cybersecurity program was inadequately staffed and did not have sufficient resources to address risks.
Unfortunately for Robinhood, it seems old habits die hard. While they have indeed revolutionized the stock trading industry, this may have been done at the expense of putting the proper standards and necessary staffing to operate effectively.
Like many new startups, their overall intentions are good, but they have a lot to learn when it comes to proper execution.
Robinhood’s Scandal – What Alternatives Can You Use?
Investors who are wary of Robinhood have several other suitable alternatives that they can try.
M1 Finance is a very popular U.S.-based trading platform that offers commission-free trading similar to Robinhood. The company is very big on helping clients to focus on investing for the long term.
Users will create what M1 calls a “pie” and then fill it with various investments like stocks and ETFs.
As future money is invested, it will be distributed across the user’s pie so that they maintain their preferred asset allocation.
In addition, M1 allows users to fractionally invest in nearly any company that they want. This means that you can get started buying companies like Amazon for as low as $1.
SoFi, the company that's already helped thousands of millennials to refinance their student loans, now also has an investing arm called SoFi Invest.
Similar to Robinhood, SoFi Invest offers commission-free trading and requires $0 to open an account. Users can choose from a wide variety of stocks and ETFs, buy fractional shares, or even enter into the world of cryptocurrency.
What’s different about SoFi is that users also get unlimited access to the company's financial advisors to help with long-term financial strategy at no extra charge.
Additionally, SoFi hosts a whole suite of other helpful financial products such as credit cards, loans, refinances, and even insurance. They’re definitely a comprehensive choice for not just investing but any other financial need you may have.
For more vetted investment trading app choices, please check out this post here.
What Do You Think About The Robinhood Scandal?
While Robinhood may have changed the stock trading industry forever by making commission-free trading commonplace, the company was still accused of wrongdoing and fined $70 million by FINRA in 2021.
For that reason, investors need to be aware of the shortcomings of Robinhood's services and may only want to consider using Robinhood for casual trading.
The basis of the 2021 FINRA penalty was related to a series of failures by Robinhood to their clients.
The other main contributors were Robinhood's lack of standards and not providing enough supervision over their brokerage services.
Leading up to 2021, Robinhood approved thousands of inexperienced users access to complex trading tools such as options trading and margin accounts. They also had extended blackouts where customers couldn't access their accounts and lost tens of thousands of dollars.
Less than a year earlier, Robinhood was slapped with a fine from the U.S. SEC for failing to disclose fees it charged customers on its trades. And as recently as August 2022, the New York State Department of Financial Services issued a $30 million penalty against Robinhood’s crypto division.
As always, investors need to be vigilant about who they choose to partner with and where they put their money.