Learn how inappropriate marketing techniques and inadequate internal controls can lead to significant liability for companies involved in the purchase and sale of publicly traded securities.
Case Study: Violations of State and Federal Securities Laws
A fast-growing broker-dealer attracted many young investors with an easy-to-use App readily accessed from a smartphone. The broker was the first to allow investors to trade without a fee. Further, the app created an exciting online environment with celebration graphics, post-trade and forwards, and frequent market and trade alerts that effectively encouraged active trading.
Many of the customers were new to investing and became caught up in the excitement and action, trading at a considerably higher frequency than previous traditional investors. They were also quickly approved for sophisticated high-risk trading instruments such as margin loans and options trading which were inappropriate features for a considerable number of the approved customers.
Readers who complete this case study should be able to:
- Explain how failure to properly market products and services may lead to civil liability.
- Understand the responsibility a company undertakes when acting as an intermediary in the purchase and sale of publicly traded securities.
- Describe ways in which a company might take additional precautions in protecting itself from accusations of fraudulent conduct.
- Identify how companies must account for societal norms and customs when creating a sales platform.
- Understand the core concepts and concerns of the regulators applicable to interactions with the investing public.
Securities and Exchange Commission, transparency, online broker, Know Your Customer, Payment for Order Flow, Best Execution
The securities industry functions as one of the most critical components of our economy by raising and investing capital from investors. Many of today’s most important and valuable companies would not exist if it weren’t for the ability of companies to sell stock, and individual investors to buy stock, on publicly traded exchanges.
The Securities and Exchange Act governs the laws and rules pertaining to securities on a federal level. Individual states additionally have their own securities laws, known as Blue Sky laws, indicating the transparency intended by implementation of such laws. Companies selling their shares to the public and exchanges that support the trading of such shares are expected to adhere to the laws and standards of both The Securities Exchange Act and applicable Blue-Sky laws.
Trading of these shares originally occurred manually in face-to-face transactions. The advent of technology led to the creation of numerous online exchanges, driving down costs to make trading shares extremely affordable and more available to anyone with a bank account and internet access. As a result, a growing number of new investors have entered the trading market, often unaware of risks posed by certain trading strategies and instruments of transaction.
Millions of investors turned to Robinhood in recent years, lured by a sales pitch of “No Fee” trading and elimination of account maintenance minimums. Robinhood offered free, fast, trading through its online trading app that attracted millions of new, young customers. Robinhood rapidly grew into one of the biggest retail brokers in the country by attracting a younger generation of investors. The company became a Silicon Valley darling with a valuation of nearly $12 billion dollars.
Although Internet-savvy and not intimidated by the lure of on-line trading, many were unsophisticated retail investors with no experience trading in financial instruments. They viewed securities trading as more akin to on-line “gaming” or “sports betting.” Some securities products, like options, commodities, and digital currencies, may have been riskier (if not totally inappropriate) for all of Robinhood’s growing list of customers. Yet, Robinhood not only approved and permitted investors to trade in these instruments, it actually encouraged such practices by utilizing intricate advertising techniques within its App such as online banners, graphics and teaser trading alerts as part of the user experience.
Robinhood’s main source of revenue was predicated on Payment for Order Flow, a legally and regulatory sanctioned practice, but one with very demanding and costly compliance components. This practice was begun decades ago enabling market making firms to receive compensation by charging for their order flow in exchange listed securities. This practice engendered a great deal of industry controversy, regulatory scrutiny and media coverage. Terms such as “Bribery and Kickbacks” colored early days of the practice, the result of which even went so far as cause Congress to call brokerage industry participants in for special hearings and inquiries. Robinhood’s principal source of revenue relied upon Payment of Order Flow. Senior management failed to have a more balanced source of revenue to accommodate their business plans’
Payment of Order Flow trading typically does not lead to something known as Best Execution. Best Execution occurs when a broker dealer executes a trade at the most favorable price for a client-investor seeking to trade in a security or financial instrument. Payment of Order Flow, on the other hand, allows intermediaries to take advantage of minor fluctuations in the price of a security in executing trades with third parties. While this price dislocation is generally very minor on an individual transaction basis, the pennies add up over time when trading is executed in significant volume, such as that created and encouraged by Robinhood.
Robinhood’s questionable actions began at the initial point of entry, when the broker-dealers’ member representative reviewed the initial customer profile related to the “Know Your Customer” obligation. It was management’s responsibility for the final approval of the opening of the account. Robinhood’s use of a remote access on-line platform did not demand an in-person interview. The requirement to prepare a comprehensive and thorough account solicitation agreement and the understanding of a prospective client’s investment objectives, financial capabilities, and their knowledge of how the markets work, is a mandatory compliance requirement. More importantly, the degree of risk that the individuals’ personal financial assets could support, were essential for Robinhood’s support of their clients’ responsible investment and trading activities.
The Securities and Exchange Commission (SEC) is a governmental organization created by Congress in the early 1930s in response to the abuses in the US securities industry that led to the Great Depression. The general purpose of the SEC is to protect investors and to keep securities markets fair and functional. As part of its role, the SEC advocates for full disclosure to the public, protects investors from fraudulent and manipulative practices, and supervises and regulates certain mandatory requirements applicable to all participants in the securities industry. This includes the requirement that broker-dealers sufficiently know their client.
Massachusetts’ Blue Sky statutes mirror FINRA and the SECs requirements that require the firm and its representatives to have a reasonable basis that each customer has a thorough understanding of the risk and rewards of the recommended security or strategy. These obligations must be made on a case-by-case analysis of a broad array of customer specific factors to support this determination.
Robinhood’s novel use of Payment for Order Flow practices pioneered no-fee trading, garnered the attention of government investigations. Allegations focused on Robinhood management’s disregard for the vulnerability of new investors to trading in securities, particularly with respect to the quick and easy approval of active trading and trading using complicated financial instruments. These investigations also uncovered the fact that Robinhood’s senior management, and other responsible parties such as department and line managers, ignored internal warnings and concerns expressed by employees that investors engaged in overly risky trading.
The Securities and Exchange Commission, along with the State of Massachusetts brought charges against Robinhood, predicated on Robinhood’s failure to appropriately and diligently comply with rules relating to Know Your Customer requirements.
Massachusetts went even further, accusing the startup of riding to success by “unscrupulously pushing unsophisticated customers into risky investments” should have been an obvious consequence of Robinhood management’s aggressive marketing, targeting new young investors, many of which were intrigued by the advent of new derivative and digital products (ETF, options, Bitcoin,etc.) and their no cost, on-line remote access. Marketing terms such as Free, Fast, and Easy are like chum or bait, for what may be characterized as roiling the investment waters; highlighting potentially unsuitable or inappropriate product or investment activities. Several of Robinhood’s younger investors had huge losses. One investor committed suicide after accumulating a negative balance of $730,000 dollars.
Failure to comply with financial and compliance requirements were other key points of contention. As was an assertion that development and programming algorithms should have been predicated on “Best Execution” rather than on “Payment for Order Flow” compensation agreements with various dealer and exchange market execution facilities.
Robinhood’s failures to comply with very basic and fundamental requirements specified by securities rules and laws led to various abuses of Know Your Customer, Investor Suitability, Best Execution, Payment for Order Flow, Transparency, and overall management failures to maintain a Culture of Compliance.
Ultimately, without admitting or denying the charges, Robinhood settled the SEC charges with an Acceptance, Waiver and Consent (AWC) which resulted in a fine of $65 million. It also took a major reputational hit and must submit to continuing rigorous oversight by both the SEC and State regulators–placing costly management and financial burdens on the organization. Furthermore, Robinhood now faces an existential threat to its principal source of revenue generated by Payment Order Flow.
While regulators approved Robinhood’s Payment for Order Flow practices they demanded more expansive transparency and supporting documentation that would evidence the participation in the practice by both the broker and the market makers, along with an obligation to comply with Best Execution practices that validate the quality of the execution for the customers’ orders and the brokers’ choice of routing and execution venues.
Every broker-dealer should be thoroughly and comprehensively informed about their customers. They should know each client’s investment objectives, background relating to financial resources, knowledge of how markets work in general (specifically as it relates to more complex, esoteric products such as options, commodities, derivatives, etc.), and the risks involved in their trading activities. Such knowledge requires all broker-dealers to have well-informed, knowledgeable, registered representatives, agents, and other appropriate personnel available to inform and maintain these customer information requirements, applying reasonable diligence to acquire essential facts.
These compliance best practices are even more demanding where broker-dealers allow prospective clients to avail themselves of registration and use of an online brokerage and trading platform. In such instances, the software and networks serving as the backbone infrastructure must be maintained at a level to support an appropriate level of network capacity. It should also include complementary software to implement and support the requirements of a Culture of Compliance for the benefit of all the broker-dealer’s clients and its support personnel.
As with many new start-ups, Robinhood should have been much more comprehensive and demanding in their management and oversight of their compliance practices, procedures and checklists. Not only with their account opening process, but throughout the resulting investment and trading activities that ensued. Training of all employees, predicated on a comprehensive compliance manual, distributed to all employees, along with required procedures and checklists, needs to be diligently adhered to at every level of a firm’s activities. Management responsibility includes demanding regulatory compliance to develop, maintain and ensure an ongoing Culture of Compliance.
Business professionals should understand the costs and consequences of misbehavior in order to avoid behavior that may lead them into government investigations or white-collar criminal prosecutions. Knowledge and transparency serve as the best preventive measures and curative disinfectants.
New and innovative means for online trading will undoubtedly continue to evolve. They will, however, require greater transparency and include more effective direct outreach and interactive communication with clients. Not simply product marketing, but actual product education. At a minimum, customers must receive appropriate and comprehensive data to best inform them of underlying company practices which may conflict with the customers’ best interests and instruct customers regarding risky trading practices that may undermine the safety and security of their capital. This should not only be for actions by their customers, but also for information pertaining to markets in general, in order to enhance the client’s knowledge and expectations related to trading on US stock exchanges.
Broker dealers serving as conduits for investor trading must also increase their interaction with their regulators, as to intentions and compliance efforts with regards to policies and practices that may reflect on their customers. This openness and intention to engage, clarify and maintain an ongoing dialogue with regulators, should result in greater knowledge and capabilities for online brokers and their clients.