The Securities Litigation Expert Blog

Robinhood Recommendations - Rise of the Machines

Posted by Jack Duval

Feb 9, 2021 7:42:31 AM

accelerant jack duval robinhood litigation - hal 9000 image

Your broker will see you now.

In my first two posts in this series, here and here, I focused on Robinhood's trading restrictions and the potential litigation from those actions.

In this post, I want to shift focus to examine potential liability that could arise from Robinhood's business model and use of algorithms.

This potential liability revolves around Robinhood’s communications to its clients and if those communications constitute recommendations.

Recommendations

Does Robinhood make recommendations to its clients?

At first blush, the obvious answer is “no”. Robinhood is an online broker-dealer that facilitates its clients making self-directed trades through an app. There is no traditional human broker making recommendations to the client, so how could a recommendation have been made?

Upon deeper inspection, the obvious answer is very likely incorrect.

FINRA

First, it is important to review how FINRA defines a "recommendation".

FINRA Notice to Members (“NTM”) 01-23 - Online Suitability, gives clear guidance about what constitutes a recommendation. FINRA writes: 

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...

 

Another principle that members should keep in mind is that, in general, the more individually tailored the communication to a specific customer or a targeted group of customers about a security or group of securities, the greater likelihood that the communication may be viewed as a "recommendation".[1]

To simplify, there are two criteria that must be met to satisfy FINRA's definition of a recommendation:

  1. A suggestion to transact, (the “call to action”); and,
  2. Specificity to the customer.

For context, NTM 01-23 arose from the proliferation of online brokerage firms during the technology bubble in the late 1990's. These firms would frequently publish "Top 10" stock lists and other types of equities hyping on their websites.

The “Top 10” lists and similar communications clearly meet the call to action prong of the FINRA criteria - the firm was suggesting its clients invest in the listed securities. However, those lists clearly failed the specificity prong - the lists were posted on the firm’s website and were not specific to any individual client.

In a sense, these communications were like billboards on a highway.   Anyone driving down the highway could see them, not just one person or one group of person that had been targeted because of their specific traits.

Importantly, NTM 01-23 specifically addresses “electronic” recommendations, meaning those made by a computer and not by a human speaking to the customer. FINRA writes: 

… NASD Regulation believes that the suitability rule applies to all “recommendations” made by members to customers – including those made via electronic means – to purchase, sell, or exchange a security. Electronic communications from broker/dealers to their customers clearly can constitute “recommendations.” The suitability rule, therefore, remains fully applicable to online activities in those cases where the member “recommends” securities to its customers.[2] (Emphasis added)

Electronic communications to clients is an integral part of Robinhood’s business model and strategy. As will be discussed below, Robinhood did not use the “billboard” approach to its electronic communications. It targeted specific customers (based on their unique traits) with specific suggestions

Robinhood's Business Model

First and foremost, Robinhood is a technology company. It has applied a number of social media business techniques to a broker-dealer business and the results have been spectacular.

The Massachusetts’ Securities Division, filed a complaint against Robinhood (“MA Complaint”) in December 2020. The MA Complaint describes the firm’s business model and growth: 

Robinhood is a broker-dealer that offers commission-free trading for stocks and options. In lieu of commissions and fees, Robinhood earns revenue through a process known as payment for order flow. Payment for order flow is a process in which market makers or exchanges pay broker-dealers to route trades to the market maker or the exchange for execution. Therefore, the more trades Robinhood customers execute, the more revenue Robinhood receives from market makers or exchanges.[3]

 

Robinhood's stated mission is to 'democratize finance for all'. In its attempt to 'democratize' investing, Robinhood has targeted younger individuals with its advertising, many of whom have limited or no investment experience. According to Robinhood, the median customer age is 31 years old.[4]

 

Since its founding in 2013, Robinhood has experienced a rapid growth in its customer base. Between 2016 and October 2018, Robinhood grew its customer accounts from approximately one million to approximately six million, a 500% increase. Between the end of 2019 and May 2020, Robinhood grew its customer accounts from approximately ten million to approximately thirteen million, an increase of 30% in only a few short months. [5]

 

During this period of exponential growth, Robinhood used advertising and marketing techniques that targeted younger individuals, including Massachusetts residents, which little, if any, investment experience. The median age of a Robinhood customer has been reported as 31 years old and approximately 68% of Massachusetts customers approved for options trading on the Robinhood platform identified as having no or limited investment experience.[6]

Perhaps the social media technique most heavily used by Robinhood is that of gamification.

Gamification

“Gamification” is the use of elements typical in game playing to encourage engagement with a product or service.[7] The MA Complaint states that Robinhood: 

(Used gamification) to encourage and entice continuous and repetitive use of its trading application.[8]

 

Once individuals become customers, Robinhood relentlessly bombards them with a number of strategies designed to encourage and incentivize continuous and repeated engagement with its application. The use of these strategies is often referred to as gamification: the application of typical elements of game playing to other activities, typically as a marketing technique to boost engagement with a product or service.[9] (Emphasis added)

Robinhood’s “strategies designed to encourage and incentivize continuous and repeated engagement with its application” includes the following: 

Robinhood sends push notifications to customers to encourage interaction with the application and trading.[10]

 

A customer that has not yet traded in their account may receive a push notification that states: 'Top Movers: Choosing stocks is hard. [flexing bicep emoji] Get started by checking which stock prices are changing the most'. Upon clicking on the push notification, the customer redirects to the aforementioned Top Movers list.[11] (Emphasis added)

 

Customers may also receive a push notification that states, 'Popular Stocks: Can't decide which stocks to buy [thinking emoji] Check out the most popular stocks on Robinhood.' Upon clicking on the push notification, the customer redirects to the aforementioned 100 Most Popular list.[12]

Robinhood’s Recommendation Engine

I believe the push notifications were recommendations and the algorithms Robinhood used to communicate with the firm’s clients constitute a recommendation engine.

It is almost certain that all the push notifications sent by Robinhood to its clients are tailored to groups that meet specific criteria, such as having not made a trade after opening an account. This is not “billboard” advertising. This was specific communication sent to specific clients based on specific traits they shared.

By suggesting trades to specific clients based on their specific account traits, the communication meets both prongs of the FINRA definition of a recommendation.

Most troublesome is that a push notification based on the number of times the client has traded is not based on information that would enable one to determine client suitability, such as the client’s risk tolerance and investment objective.

The Best Interest Standard

I have written extensively on SEC Regulation Best Interest (“RBI”) and will only review the basics here. In short, RBI requires a broker-dealer to know both the client and the investment in order to make a best interest recommendation. In the final RBI release, the SEC wrote: 

… when making a recommendation to a particular retail customer, broker-dealers must weigh the potential risks, rewards, and costs of a particular security or investment strategy, in light of the particular retail customer’s investment profile. As discussed above, a broker-dealer ‘s diligence, care, and skill to understand the potential risks, rewards, and costs of a security or investment strategy should generally involve a consideration of factors, depending on the facts and circumstances of the particular recommendation and the particular retail customer’s investment profile…[13]

As discussed in the MA Complaint, Robinhood’s recommendation engine appears to have failed to know the investor or the investment in any meaningful way.

First, if an algorithm bases its trade recommendation to a client off of the client's previous number of trades, the recommendation is based off of factors that have nothing to do with the client's investment objective, risk tolerance, and other relevant facts and circumstances, and thus did not consider the investment profile of the clients it made recommendations to.

Second, if the algo is suggesting trades in stocks that have the biggest daily percent change or are the most heavily traded on the platform, the algo only knows those stocks in the most trivial manner (ultra short-term performance and popularity), and in ways that cannot be used to evaluate their appropriateness for each client.

Any recommendation made in ignorance of the investor and investment completely fails the RBI standard of care.

Conflicts of Interest

Another relevant part of RBI that is violated in this scenario is the conflict of interest obligation, which states, in part: 

The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to:

 

(B) Identify and mitigate any conflicts of interest associated with such recommendations that create an incentive… to place the interest of the broker, dealer, or such natural person ahead of the interest of the retail customer.[14]

If Robinhood’s algorithms were making recommendations based on the number of trades (or lack thereof) a client had made, then the recommendations were made purely to generate revenue for the firm. This is a blatant conflict of interest.

Indeed, it’s just a form of high-tech churning with bots making the recommendation instead of brokers.

Liability

If Robinhood has been making blatantly conflicted and demonstrably unsuitable recommendations to its clients via push notifications, and those clients have lost money on the recommended trades, it would appear the firm has significant liability under RBI.

Furthermore, unlike traditional cases where the broker and client typically give conflicting testimony about what was said as part of the recommendation, or if there was a recommendation at all, there will be none of that here.

The algorithms are likely very simple: 

  1. Call the number of trades for all accounts;
  2. Filter for accounts that have not traded since opening; and,
  3. Send push notification to the filtered list account holders.

The algorithm will establish the basis of the recommendation to each client. The push notifications will establish what was “said”. The statement records will show if the client traded those securities after the push notification was received and the profit and loss on those recommended transactions.

The algorithms, push notifications, and statements should all be discoverable and would establish a causal chain from Robinhood’s selection of the clients for the push notification to the profit and loss of those recommended transactions.

__________

Notes:

[1]      FINRA Notice to Members 01-23; Online Suitability; 2. Available at: https://www.finra.org/rules-guidance/notices/01-23; Accessed February 4, 2020.

[2]      Id. FINRA use to be known as “NASD”.

[3]      In the Matter of: Robinhood Financial, LLC; Administrative Complaint; Docket No. E-2020-0047; 8. Available at: https://www.sec.state.ma.us/sct/current/sctrobinhood/MSD-Robinhood-Financial-LLC-Complaint-E-2020-0047.pdf; Accessed February 4, 2020; In Massachusetts, a broker-dealer is a fiduciary. The MA Complaint was filed on December 16, 2020, before the short squeeze mania.

[4]      Id. at 9.

[5]      Id. at 3.

[6]      Id.

[7]      See Merriam-Webster; s.v. “gamification”. Available at: https://www.merriam-webster.com/dictionary/gamification; Accessed February 5, 2021. I am paraphrasing above.

[8]      Id. at 2.

[9]      Id. at 4.

[10]    Id. at 13.

[11]    Id. at 14.

[12]    Id.

[13]    17 CFR Part 240; Regulation Best Interest: The Broker-Dealer Standard of Conduct; 270. Available at: https://www.sec.gov/rules/final/2019/34-86031.pdf; Accessed February 8, 2021.

[14]    17 CFR Part 240; Regulation Best Interest: The Broker-Dealer Standard of Conduct a(iii)(B); 765-8. Available at: https://www.sec.gov/rules/final/2019/34-86031.pdf; Accessed February 8, 2021.

 

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Topics: FINRA, Conflicts of Interest, suitability, securities litigation, investment recommendation, SEC Regulation Best Interest, Robinhood

GameStop Litigation - Part 2

Posted by Jack Duval

Jan 29, 2021 3:46:12 PM

This is the second post in my series on potential litigation arising from the trading restrictions imposed by Robinhood and other firms on GameStop and other securities involved in the recent short squeezes. The first post can be found here.

Broker-Dealer Risks

Broker-Dealers (“BDs”) can get burned by margin clients blowing up. But that’s not what happened to Robinhood or any other BD yesterday.

As of 10am Thursday morning, every owner of Robinhood stock and call options (what the Redditors were buying) was profitable because the stock was at an all-time high.

The risk to a BD is that their margin customers take large losses in excess of the equity in their accounts. In these instances, the BD has to make up the difference to their clearing firm, if that amount is greater than the firm’s equity, it is bankrupt.

The way BDs manage this risk is to change client margin requirements to increase their client's account equity and/or to sell out client positions if their equity falls below a certain level.

Robinhood did increase the margin requirements on GameStop and the other names that were part of the ongoing short squeeze on Wednesday, January 27th.[1]

Clearing Firm Margin Requirements

BDs, like their clients, are subject to their own margin requirements from their clearing firms. Also just like their clients, BD margin requirements change, typically under a formula that includes volatility as an input. As volatility increases, so does the margin requirement of the BD.

When a BD's margin requirement increases, it must post more collateral with its clearing firm.

Robinhood CEO Vlad Tenev said in a CNBC interview this morning that the firm tapped its bank credit lines proactively, meaning that it did so before it received margin calls from the Robinhood’s clearing firms.[2] Further, Tenev stated that Robinhood had “no liquidity problem, and that: 

By drawing on our credit lines, which we do all the time, as part of normal day-to-day operation, we get more capital that we can deposit with the clearinghouses. And that will allow us to enable ideally more investment with fewer restrictions.[3]

If there was no liquidity problem and Robinhood drew on its credit lines to bolster its capital position with its clearing brokers, there should have been no reason to restrict trading in GameStop and the other short squeeze names.

GameStop Volatility

There is no doubt that GameStop volatility has been rising, but it had already risen significantly by Wednesday, January 27, and trading had not been stopped. Again, if Robinhood had bolstered its capital position on January 27th and 28th, why restrict trading yesterday?

Chart 1: GameStop 10, 30, 90, and 120 Day Historical Volatility

accelerant jack duval GME historical volatility chart

 Furthermore, overall market volatility, measured by the VIX Index fell from 37.21 on Wednesday to 30.21 on Thursday, a decline of 18.8 percent.[4]

This is important, because Robinhood clients hold many more securities that GameStop and the other short squeeze names. Thus on an aggregate basis, it is possible that the volatility on the combined Robinhood securities declined on January 28th.

In short, it would appear that Robinhood's proactive trade restrictions were implemented not because the firm had run out of money, but because the firm was worried about running out of money.

However, Robinhood was fully capitalized Robinhood and acted on these worries by preventing its clients from purchasing GameStop and other short squeeze names and only allowing closing transactions.

While it is certainly prudent for Robinhood to act proactively to protect its business it cannot be reckless or negligent in how it does so.

As can be seen in Chart 1, above, the volatilities of GameStop had been rising starting on January 13th, when the 10 day volatility spiked from 100 to 258.

On January 26th, the 10-day volatility spiked again from 308 to 394. Ultimately, the 10-day volatility peaked out at 688, nearly a 10x increase from the January low of 77.

However, Robinhood had lived through other 10x increases in single stock volatility.

Chart 2: Tesla 10, 30, 90, and 120 Day Historical Volatility

accelerant jack duval tesla historical volatility chart

 

Chart 2, above, shows the 10-day Tesla stock volatility increasing from 18 to 210 in the three months leading to the climax of the COVID selloff in March 2020. Furthermore, this was a time when all equity volatilities were spiking to extreme levels.

In order to protect the firm, prudent risk management would dictate that Robinhood:

  • Raise the margin requirements on its clients in the short squeeze names;
  • Bolster the firm's capital position by drawing on bank lines; and,
  • Raise additional capital from its backers (which have included some bold-faced venture capital names that surely had cash available on short notice).

Robinhood did all three, but not before it helped manipulate a catastrophic decline in the GameStop stock price.

Impact of Broker-Dealer Trading Restrictions

Robinhood implemented its closing-position only trading restrictions at 10am yesterday, January 28th, 2020.

During the day, the SEC halted trading in GameStop 19 times.

These two factors appear to have panicked investors into selling (which is, of course, the only option they had at many BDs yesterday).

Chart 3: January 28, 2021 GameStop Intraday Price Chart

accelerant jack duval GameStop Intraday Chart

Yesterday from 10am to 11:24am, GameStop stock declined by nearly 77 percent.

What's more instructive is that the price was effectively "limit down" multiple times from 10am after almost every trading halt through 11:24am.

This means it was very difficult to sell the stock. It essentially went like this:[5]

  • 10am, Robinhood told clients they could only close out positions (i.e. sell stock or long call options, or buy back short positions), this caused the stock to decline;
  • 10:03am the SEC implemented the first trading halt in GameStop;
  • 10:08am the trading halt was lifted;
  • 10:16am the stock had declined by over eight percent;
  • 10:17am the SEC implemented the second trading halt in GameStop;
  • 10:22am the trading halt was lifted;
  • 10:39am the stock declined by roughly 11 percent; and,
  • 10:40am the SEC implements the third trading halt.

 This cycle repeated seven more times until 11:24am, when the stock has an intraday peak to trough decline of almost 77 percent.

Client Losses

It is not clear how much money was lost during the one hour and 24 minutes that encompassed the 77 percent decline.

However, it is certain that some investors experienced large losses, especially those that had purchased call options over the past few days.

Liability

There have already been two class-action cases filed against Robinhood, including Nelson v. Robinhoood Financial et al in the Southern District of New York.

There are many issues involved. On Thursday, Robinhood management pointed to their own margin calls from clearing firms, but this morning said there was no liquidity crunch. If the firm implemented the trading restrictions when it did not need to, under the perception that it might face a cash crunch at some later date, that is problematic.

Instead of restricting trading due to a potential problem, Robinhood should have bolstered its capital and/or undertaken other measures in advance of those potential needs. The firm had plenty of notice as the short squeezed stock appreciation gathered pace over the past month.

Finally, Robinhood claims to have raised an additional $1 billion from its existing backers (in addition to the reported $200 million in bank line draws). If that’s true, why is the firm only allowing the purchase of one additional GameStop share as of 3:15pm today.[6] Something doesn’t add up there.

For attorneys contemplating bringing a complaint, it is good to keep in mind that Robinhood has plans to IPO this year at a price that would value the firm at around $20 billion. The firm has already had regulatory issues and had to pay an SEC fine of $65 million on December 17, 2020 for violations of FINRA's Best Execution rule.

Robinhood will not want to IPO under a cloud of litigation uncertainty and may be more willing to settle cases because of that.

Conspiracy!

What would the Redditor/Robinhood story be without a good conspiracy? This one is brought to you by Congressman Paul Gosar, D.D.S.:

Melvin Capital Management is owned by the parent company “Citadel, LLC” which, according to a Bloomberg Report, gave Robinhood roughly 40% of their revenue (through payment for order flow). Knowing the involvement Citadel has with Robinhood, it is clear that the actions taken today were motivated by anti-competitive reasons not for concerns of volatility claimed by Robinhood. Because of this blatant conflict of interest and obvious monopolistic activity, I am calling on an immediate investigation by the U.S. Department of Justice into Robinhood and the hedge fund of Citadel, LLC.[7]

 Let the investigations begin.

__________

Notes:

[1]      Robinhood ramps up margin requirements on zooming GameStop, AMC; Matt Egan; CNN Business; January 27, 2021. Available at: https://www.cnn.com/business/live-news/stock-market-news-012721/h_f037344e14a037160cc724607ff72da0#:~:text=Robinhood%2C%20the%20free%20trading%20app,initial%20margin%20requirement%20and%20maintenance; Accessed January 29, 2021.

[2]      Robinhood CEO: Tapping Credit lines proactive, not a sign of cash crunch in GameStop frenzy; Kevin Stankiewicz; CNBC; January 29, 2021. Available at: https://www.cnbc.com/2021/01/29/robinhood-ceo-vlad-tenev-tapping-credit-lines-proactive-to-help-lift-gamestop-trading-limits.html; Accessed January 29, 2021.

[3]      Id.

[4]      Source: Bloomberg.

[5]      Bloomberg News reported the Robinhood trading restrictions at 9:43am on January 28, 2021, however the New York Times reported on after-hours trading restrictions the night before at 6pm. See, Trading platforms are limiting trades of GameStop and other companies; Gillian Friedman and Tara Siegel Bernard; The New York Times; January 27, 2021. Available at: https://www.nytimes.com/2021/01/27/business/gamestop-td-ameritrade-robinhood.html?partner=bloomberg; Accessed January 29, 2021. SEC Trading Halts obtained from NasdaqTrader.com. Available at: http://nasdaqtrader.com/trader.aspx?id=TradingHaltHistory; Accessed January 29,2021.

[6]      Robinhood raises $1bn from investors and taps banks at end of wild week; Michael Mackenzie, Eric Platt, James Fontanella-Khan, and Philip Stafford; Financial Times; January 28, 2021. Available at: https://www.ft.com/content/9a1b24e6-0433-462a-a860-c2504ea565e4; Accessed January 29, 2021.

[7]      Letter of Paul A. Gosar, D.D.S. to Activing Attorney General Monty Wilkinson; January 28, 2021. Available at: https://twitter.com/PJ_Matlock/status/1354974631619395591/photo/1; Accessed January 29, 2021.

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Topics: FINRA, securities litigation, Bantam Inc., GameStop, Trading Restrictions, Trading Halt, Reddit, Robinhood

GameStop Litigation

Posted by Jack Duval

Jan 28, 2021 11:51:17 AM

Yesterday and this morning, TD Ameritrade, Robinhood, and other firms restricted trading in GameStop, AMC, and other heavily shorted stocks that have been undergoing tremendous short squeezes over the past few weeks.

GameStop Chart

Jack Duval Accelerant GameStop litigation image

Source: Bloomberg

Regulatory Halts v. Trading Restrictions

For clarification there is a difference between a Regulatory Halt, which can be issued by FINRA or the SEC, and a broker-dealer ("BD") restricting trading in a security.  The former is common and happens every day, usually due to a large move (up or down) in a stock.  The regulator typically contacts the issuer to see if there is news that needs be be disclosed and will remove the halt after their questions have been answered.  (Frequently, there is no news from the company.)

A BD-initiated trading restriction is much less common.  When they do happen, they are usually for clients a firm wants to fire.  They ask the client to leave and tell them they will only accept closing orders, i.e. sales of securities held long, or purchases of securities held short.

This morning, Robinhood announced it would accept only closing orders for GameStop, AMC, and other securities.  They had already raised the margin requirements for these securities.

Robinhood Customer Agreement

The Robinhood Customer Agreement explicitly allows for the firm to "prohibit or restrict" trading in securities, without notice.

Robinhood Customer Agreement Extract

robinhood account agreement

Litigation Implications

While Robinhood, and most likely all BDs, have the ability to restrict client trading in securities, doing so raises a host of issues.  Some of those include:

  • Was the implementation of the trading restriction commercially reasonable?
  • If the BD allowed the clients to buy the security and then only allowed sales of the same security, are they engineering a decline in the security?  That is, if owners can only sell a security and no one can buy, there is only one way for the security to trade - down.
  • If all BDs implement closing-only restrictions, they themselves are engaging in market manipulation, guaranteeing a price decline and losses for investors.
  • If a client has an open options position, is the BD preventing the client from hedging their position via an opening transaction in the underlying or another option?
  • It is likely that FINRA has been in consultation with the BDs about these restrictions, which would seemingly raise the same liability issues for the regulator.
  • Are these restrictions being applied to institutional investors as well as retail investors?  For instance, are the options market makers able to trade in these names freely?  What about hedge funds and other institutions?
  • If the restrictions have not been implemented uniformly, it raises serious self-dealing issues.  FINRA's members are BDs and are heavily connected to institutional investors such as hedge funds.  If the regulator coordinated a member-wide closing trade only restriction for retail investors, it would benefit the hedge funds (who have been short) at the expense of the retail investors.

As I was writing this, it would appear that the trading restrictions have negatively affected the GameStop stock price.  It has declined by 67 percent from the peak today (from roughly $450 to about $126).

GameStop Intraday Chart

gamestop intraday chart

Source: Bloomberg

I'll have more on this as developments continue.

__________

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Topics: FINRA, securities litigation, Bantam Inc., GameStop, Trading Restrictions, Trading Halt

SEC Regulation Best Interest - The Five-Part Test

Posted by Jack Duval

Aug 1, 2018 8:51:34 AM

This post continues my blog post series on SEC Regulation Best Interest.

A note to long-time readers of this blog:  You may have noticed that I haven’t been posting for a while.  This is due to the launching of my RIA firm Bantam Inc.  I have posted over 20 blog posts on that site in the past three months.  They cover investments and should be of interest to anyone involved with securities litigations.  There are also many posts with attorney-related content.  You can find those here.

 

Accelerant SEC Regulation Best Interest - five-part test

 

The SEC Regulation Best Interest Standard

One of the most significant changes from the FINRA suitability regime to SEC Regulation Best Interest (“RBI”) is a move from subjectivity to objectivity. 

While there are some objective elements to suitability, such as what needs to be included in a client profile, the actual suitability determination is subjective.  This will change under RBI.

What the SEC has proposed is not only a new standard of best interest, but a five-part test to satisfy that standard.

The SEC defines the best interest standard as follows:[1]

The proposed standard of conduct is to act in the best interest of the retail customer at the time a recommendation is made without placing the financial or other interest of the broker-dealer or natural person who is an associated person making the recommendation ahead of the interest of the retail customer.

The Five Elements to Satisfy the Best Interest Standard

The SEC then lays out the five elements that must be met in order to satisfy RBI:[2]

This obligation shall be satisfied if:

  1. The broker-dealer or a natural person who is an associated person of a broker-dealer, before or at the time of such recommendation reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship, and;
  2. (Disclosure of) all the material conflicts of interest associated with the recommendation;
  3. The broker-dealer or a natural person who is an associated person of a broker-dealer, in making the recommendation, exercises reasonable diligence, care, skill, and prudence;
  4. The broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all conflicts of interest that are associated with such recommendations, and;
  5. The broker-dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations. (Emphasis added)

A few quick points on the Best Interest standard.

First, one similarity between RBI and FINRA suitability is that both are recommendation-based rules.  This means the best interest obligation is episodic and only arises at the time of the recommendation.  (As with FINRA suitability, the exception to this arises from an explicit recommendation to hold.[3])

This is a critical distinction between RBI and the fiduciary standard to which registered investment advisors are held.  A fiduciary is held to the best interest standard in all their dealings with the client, not just for recommendations.  Also, the fiduciary standard is continuous and operates throughout the relationship, not just when recommendations are made.

Retail Customers

Second, RBI applies to “retail customers” which only includes individuals (and their trusts and IRA accounts) and not to any business entities they may own.  The SEC defines a retail customer as:[4]

“… a person, or the legal representative of such person, who: (1) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer or a natural person who is an associated person of a broker or dealer, and (2) uses the recommendation primarily for personal, family, or household purposes.”

The Commissions preliminarily believes this proposed definition is appropriate, and in particular, the limitation to recommendations that are “primarily for personal, family or household purposes,” as we believe it excludes recommendations that are related to business or commercial purposes, but remains sufficiently broad and flexible to capture recommendations related to the various reasons retail customers may invest (including, for example, for retirement, education, and other savings purposes).

There is no such distinction under the fiduciary standard.  Under RBI, business accounts would come under the FINRA suitability rules.

In my next post, I will unpack the five elements that must be satisfied.

Note to securities litigators:  I am working on a white paper on RBI and as part of that have been conducting a survey of attorneys involved with customer disputes.  If you would like to participate in the survey (it’s only six questions), please send me an email at: jack@accelerant.biz to schedule a call.

_______

Notes:

[1]           SEC Regulation Best Interest; Release # 34-83062; April 18, 2018; 1.

[2]           Id. at 1-2.

[3]           Id. at 82.  “The Commission proposes to apply Regulation Best Interest to recommendations of any securities transaction (sale, purchase, and exchange) and investment strategy (including explicit recommendations to hold a security or regarding the manner in which it is to be purchased or sold) to retail customers.”  Emphasis added.  Notes omitted.  FINRA has identical language under Regulatory Notice 12-25 at Q7.

[4]           Id. at 83-4.  Notes omitted.

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Topics: FINRA, Investment Suitability, fiduciary duties, SEC Regulation Best Interest, Best Interest five elements

The Historical Origins of Fiduciary Duties

Posted by Jack Duval

Jun 21, 2018 8:36:41 AM

This post continues my blog post series on fiduciary duties and the changing regulatory landscape around a unified fiduciary standard of care for investors.

Accelerant - Jack Duval - Fiduciary Duties Expert Witness

Statue of Cicero

Given the tremendous amount of ink that has been spilled regarding the DOL Fiduciary Rule and now SEC Regulation Best Interest, I thought it would be useful to review the existence of fiduciary rules throughout history.

The idea of a fiduciary duty has existed from the beginning of humanity’s codification of the rules by which it would live.  Indeed, fiduciary duties have been central to the functioning of societies from ancient to modern times and from East to West.

In the most simple terms, a fiduciary duty arises when one person relies on another to perform a task or service for them.  The duty arises from the dependence of the one on the other.  In more modern language, trust and confidence is being reposed by the principal in the agent to carry out the agreed upon work.

Fiduciary Duties Throughout History

Perhaps the first known fiduciary duties exist in Hammurabi's Code from 1790 BC.[1]

Rules of agency, reflected in Hammurabi’s laws, developed along with commerce in Ancient Mesopotamia.  The laws primarily discuss situations in which a tamkarum, or principal/merchant, gives a samallum, or agent, either money to use for travel and for investments or purchases, or goods for trading or selling.

The Bible also has many fiduciary-related quotes, the most famous of which may be:[2]

No man can serve two masters: for either he will hate the one, and love the other; or else he will hold to the one, and despise the other.  Ye cannot serve God and mammon.

Jumping to the East, somewhere between 475 and 220 BC, Confucius wrote in The Analects a heuristic for fiduciaries: “In acting on behalf of others, have I always been loyal to their interest?”[3]

From Ancient Greece, Plato’s Republic could be read as a metaphor for the fiduciary duties of leaders to their constituents, and the whole education process of philosopher-kings as instilling these virtues. 

The Roman’s coined the term “fiduciary” in their laws and defined it to mean:[4]

a person holding the character of a trustee, or a character analogous of a trustee, in respect to the trust and confidence involved in it and the scrupulous good faith and candor which it requires.

Cicero also wrote of fiduciary obligations between agent and principal, known by the expressive terms: “mandatory” and “mandator”, respectively.  “An agent who shows carelessness in his execution of trust behaves very dishonorably and ‘is undermining the entire basis of our social system’.”[5]

Making a great leap across time, we come to Anglo-American law and the English Courts of Equity.  Scholars Aikin and Fausti write:[6]

Courts of Equity granted relief in numerous circumstances involving one person's abuse of confidence and, over time, concrete rules and precise terms related to fiduciary relationships began to form as Equity evolved.

The term "fiduciary" itself was adopted to apply to situations falling short of "trusts" but in which one person was nonetheless obliged to act like a trustee.

The second point makes sense because in non-trust fiduciary situations, the principle still owns the property, whereas in the trust situation, ownership of the asset(s) have been transferred to a trust which the trustee oversees.

Lastly, we get to American Law and Benjamin Cardozo, who, in Meinhard v. Salmon, wrote what are probably the most cited words on fiduciary duties:

Many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties.  A trustee is held to something stricter than the morals of the market place.  Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.  As to this there has developed a tradition that is unbending and inveterate.  Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the "disintegrating erosion" of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher that that trodden by the crowd.  It will not consciously be lowered by any judgment of this court.

Interestingly, the undermining of “the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions” is what is now contemplated in SEC Regulation Best Interest.  The SEC seeks to dress up FINRA suitability rules in the raiment of fiduciary language without the “uncompromising rigidity” of fiduciary law.

_______

Notes:

[1]       Keith Loveland, JD, AIFA, CIDA.  Available at: http://solisinvicti.com/books/Law/Fiduciary%20Law.pdf.  Accessed June 19, 2018.

[2]       Matthew 6:24; KJV.  Available at: http://biblehub.com/kjv/matthew/6.htm.  Accessed June 19. 2018.

[3]       Confucius; The Analects; Translated by Arthur Waley; Routledge; London and New York; 1938; 84.

[4]       Blain F. Aikin et al; Fiduciary: A Historically Significant Standard; B.U. Law Review; 158.  Available at: https://www.fi360.com/main/pdf/BULawReview_AikinFausti_Fall2010.pdf; Accessed June 21, 2018.

[5]       Id.

[6]       Id. at 159.

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Topics: FINRA, Investment Suitability, dol fiduciary rule, fiduciary duties, SEC Regulation Best Interest

FINRA's Proposed Changes to the Churning Rule

Posted by Jack Duval

May 29, 2018 8:03:39 AM

Accelerant - FINRA - Churning - Quantitative Suitability - Jack Duval

On April 20, 2018, FINRA issued Regulatory Notice 18-13 – Quantitative Suitability, requesting comments on amendments to Suitability Rule 2111.  This is the first FINRA response to SEC Regulation Best Interest.  In it, FINRA is trying to square the existing suitability rule with a new proposal in SEC Regulation Best Interest.[1]  (My writings on SEC Regulation Best Interest can be found here.)

Proposed Changes to FINRA Suitability Rule 2111.05(c) – Quantitative Suitability

The proposed changes would be made to the Supplementary Material to Rule 2111 dealing with quantitative suitability found in under section .05(c).  In short, section .05(c) would be amended to "remove the element of control that currently must be proved to demonstrate a violation (of the suitability rule) ..."[2]  What would remain are "… the obligations to prove that the transactions were recommended and that the level of trading was excessive and unsuitable in light of the customer's investment profile."[3]

The comment period expires on June 19, 2018.

According to FINRA, it is removing the control element from the rule because it is unnecessary.  FINRA writes (from the enforcement action perspective):[4]

The inclusion of the control element has its historic roots, in part, in the perceived need to ensure that the culpability for excessive trading rested with the party responsible for initiating the transactions in actions brought pursuant to the antifraud provisions of the federal securities laws.  That concern is not present under FINRA's suitability rule.  Because FINRA must show that the broker recommended the transactions in order to prove a Rule 2111 violation, culpability for excessive trading will still rest with the appropriate party even absent the control element.

... FINRA's suitability rule will continue to require FINRA to prove that the broker recommended the transactions and that the transactions were excessive and unsuitable in light of the customer's investment profile.

… The control element is an unnecessary layer of proof regarding the identity of the responsible party (i.e., the party initiating the transactions) and does not in any way touch on the proof needed to establish the underlying, substantive misconduct (i.e., the excessive trading activity inconsistent with the customer's investment profile.)  (Emphasis in the original, notes omitted)

Defining Churning

Churning is the effectuating of a trade for the sole purpose of generating a commission.  It can be for one transaction and does not have to be for multiple transactions, although the high transaction version is far more common.  (My previous post on churning can be found here.)

Critically, the level of activity and costs associated with the trading strategy must be judged against the individual client's profile, investment objective, risk tolerance, and involvement.  FINRA writes:[5]

Although no single test defines excessive activity, factors such as turnover rate, cost-to-equity ratio or the use of in-and-out trading may provide a basis for a finding of excessive trading.  A turnover rate of six or a cost-to-equity ratio above 20 percent generally is indicative of excessive trading.  However, lower ratios have supported findings of excessive trading for customers with very conservative investment objectives, while somewhat higher ratios have not supported findings of excessive trading for some customers with highly speculative investment objectives and the financial resources to withstand potential losses.

Most clients are buy-and-hold type of investors with moderate risk tolerances.  In these cases, even low levels of turnover and cost/equity ratios can be indicative of churning.  For example, I have seen such clients churned in portfolios laden with structured products.  These products were tax-inefficient and resulted in costs of 1.5 to 2 percent per year, when publicly traded equivalents would have cost a small fraction of that.

Alternately, a client with a speculative investment objective that wanted to trade actively (especially with only a portion of her assets) could have much higher turnover and cost/equity ratios without them be indicative of churning.

Another indicator is the level of commissions being assessed on each trade.  Is the broker charging full freight commissions (even if only on the buys)?  If so, this is more likely to be abusive than a broker charging firm minimum (or heavily discounted) commissions on each trade.

Ultimately, the assessment of any recommended investment strategy will be based on its comportment with the client's investment objective, risk tolerance, and overall profile.

Very few investors want to actively trade.  Most have no interest in the markets and even fewer have the leisure time to devote to following individual securities on a tick-by-tick basis.

These types of clients give their money to an investment professional and pay that professional to manage the money for them.  If speculative trading develops in these accounts, it is likely to be churning, even at low levels of turnover and cost/equity ratios.

Where an investor chooses a speculative trading strategy and knowingly takes the risks and is willing to pay the costs (which can add up quickly, even at low commission levels), that is their right.

Unfortunately, most speculative trading strategies don't work.  The investor is up against buildings full of computer servers engaged in algorithmic trading strategies that get the price data faster, and process their trades nearly instantaneously, before the client can even start typing in an order.[6]

Supervision

As always, broker-dealer supervisors will need to monitor accounts for churning.  These efforts should trigger red flags for accounts with high turnover and cost/equity ratios, those with a significant amount of the client's investable assets involved in the trading, those with large amounts of losses, and those where the trading does not comport with the client's profile.

Almost all compliance systems today can monitor for these triggers and generate exception reports for supervisors on an automated basis.

_______

Notes:

[1]      SEC Regulation Best Interest; Release No. 34-83062; Available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf;  Accessed May 24, 2018; 150.  “… Regulation Best Interest would include the existing ‘quantitative suitability’ obligation, but without the ‘control’ element.”

[2]      FINRA Regulatory Notice 18-13 – Quantitative Suitability; April 20, 2018; 1.  Available at: http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-18-13.pdf; Accessed May 24, 2018.

[3]      Id.

[4]      Id. at 3-4.

[5]      Id. at 3.

[6]      See Michael Lewis’ Flash Boys: A Wall Street Revolt explaining how algorithmic traders are scalping even the largest institutional investors.

 

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Topics: FINRA, supervision, Quantitative Suitability, Churning, turnover ratio, cost/equity ratio

Premeditated "C" Share Churning at Morgan Stanley?

Posted by Jack Duval

Apr 5, 2018 10:06:49 AM

Accelerant Jack Duval Securities Litigation Expert

On March 29, 2018, AdvisorHub broke a story about Morgan Stanley’s decision to convert all Class "C" mutual fund shares held for six or more years into load-waived "A" shares.  This is a beneficial move for clients, who will see their funds expenses ratios cut by about 1.5 percent.

Morgan Stanley brokers were not pleased with the move, which will reduce their 12b-1 fees from one percent to 25 basis points.

Some of them vowed to churn their clients in order to avoid the conversion.  (This was not an April Fool’s joke.)

Understanding “C” Share Mutual Funds

In theory, “C” shares are designed for clients who will be relatively short-term holders and want to avoid the front-end load on "A" shares and the back-end load on "B" shares.

In reality, they are an anachronistic holdover from the mid- to late-90's.  Back then, broker-dealers where trying to grow their fee-based business and saw "C" shares as a way for transactional brokers to become more annuitized.

Today, clients can get the same investment exposures at a fraction of the costs of "C" shares in ETFs, which are also much more tax-efficient.

The truth is that "C" share funds shouldn't be held for six years, and probably not at all.  Clients would be much better off in ETFs.  “C” shares have a full one percent 12b-1 fee charged annually to the customer in addition to the management fee and other expenses.  They are extremely high-fee and in almost all cases should be avoided.

Some "C" share mutual funds from other companies convert into "A" shares after 10 years, but again, 10 years in a “C” shares is unsuitable.

For a more detailed take on fees, see The Tyranny of High Fees blog post from our sister company, Bantam Inc.

Premeditated Churning                 

In what hopefully has Morgan Stanley CEO James Gorman losing sleep at night, AdvisorHub wrote:[1]              

Several Morgan Stanley brokers told AdvisorHub that they plan to "flip C shares, selling out of one fund into another's similar share class as they approach conversion date so that they can continue collecting the higher so-called 12b-1 fee, or trail.                                                  

"Losing 75 basis points on every six-year-old share on my team's book will cost us $300,000 in gross and $120,000 in commissions," lamented one broker, who said the team expects to "flip til the cows go home."

These brokers would be selling the "C" share funds before they convert into "A" shares, thus continuing the one percent 12b-1 fee instead of having it reduced to 25 basis points.          

This would be an unabashed churn of client accounts, and after a nine-year bull market, one that would likely have serious adverse tax consequences for the clients.

Belden Decision                       

The SEC has considered share class issues long ago and has clearly stated their position.  The share class most advantageous to the client must be purchased, or in this case, held.                      

In Belden, the SEC found that a broker buying "B" shares for a client who could have purchased load-waived "A" shares because of the amount to be invested, was violative of FINRA rules.  The Commission’s opinion stated:[2]

As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests.  The test for whether Belden’s recommended investments were suitable is not whether Book acquiesced in them, but whether Belden’s recommendations to him were consistent with Book’s financial situation and needs.

FINRA concurs:[3]

NASD (now FINRA) construes Belden as supporting the principle that the manner of purchase of a recommended security by an associated person, where that security otherwise would be suitable based on the investor’s investment objectives, risk tolerance, and financial means, can render that recommendation unsuitable, and therefore violative of 2310 (now 2110), if there is an alternative basis upon which the security can be purchased to the pecuniary advantage of the investor.  (Emphasis added)

There is no way the selling of "C" shares to prevent them from converting into load-waived "A" shares can be in the customer’s best interest.

Supervision

Churning is the effectuating of any trade for the reason of making commissions.  Many churning claims involve high turnover (trading) of securities in a client account.  However, churning does not have to involve a series of trades.  Indeed, it can be one trade.

In the event a registered representative sells a “C” share fund before its conversion to a load-waived “A” share, it would constitute a one-trade churn.

Morgan Stanley supervisory systems should be able to flag any "C" share trades that occur close to a conversion, however, some brokers may preemptively sell "C" shares when they are further away from the six-year marker.

These will also be churns, but will very likely not be flagged.

Morgan Stanley supervisors should closely monitor all “C” share transactions for abuses.

_______

Notes:

[1]       Jed Horowitz; Morgan Stanley to Squeeze Mutual Fund Sales Compensation; AdvisorHub; March 29, 2018; Available at: https://advisorhub.com/morgan-stanley-to-squeeze-mutual-fund-sales-compensation/; Accessed April 4, 2018.

[2]       See Wendell Belden, Exchange Act Release No. 47859; May 14, 2003.

[3]       NASD NTM 03-69; Fee-Based Compensation; November 2003; 746 at footnote 5.

 

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Topics: FINRA, supervision, C Share, Securities Exchange Commission, Morgan Stanley, Churning, Wendell Belden

FINRA: Santander Failed to Update Risk on Puerto Rico Munis - See Our Suitability Matrix

Posted by Jack Duval

Oct 14, 2015 10:37:00 AM

santander

Yesterday FINRA announced a $6.4 million fine and Acceptance, Waiver and Consent by Santander for sales practice and supervisory violations at its Puerto Rico offices.  (FINRA Press Release and Santander AWC - search under Case Number: 2014041355501)

The AWC and sanctions revolve around a number of failures to supervise the sales of Puerto Rico municipal bonds and closed-end funds.  The AWC highlights a number of supervisory failures, including:

  • The failure of Santander to update its proprietary risk-classification tool for the unique and changing risks of Puerto Rico municipal bonds; (See our Suitability Matrix, below.)
  • The failure to monitor for the use of margin in connection with the purchase of Puerto Rico municipal bonds;
  • The failure to monitor for over-concentrated positions in Puerto Rico municipal bonds and closed-end funds;
  • The failure to monitor for Registered Representatives selling personal Puerto Rico municipal bond holdings to their clients. 

The "Securities Master"

Santander used a proprietary risk-classification tool that categorized securities into three risk levels: low, moderate, and high.  The AWC noted the "vast majority of Santander's clients were moderate-risk investors" and that almost all the Puerto Rico municipal bonds sold to their clients were coded moderate-risk.  However, Santander did not update the Securities Master to reflect the dramatically increasing risks in the Puerto Rico municipal bond market.

The FINRA press release stated:

Santander did not review or assess the tool's Puerto Rico municipal bond risk classifications following significant market events such as the December 13, 2012, Moody's downgrade of certain (bonds) to one level above junk.

Santander and its Registered Representatives Sold Their Puerto Rico Municipal Bonds While Customers Held or Purchased Them

While Santander was holding its moderate risk classification steady for Puerto Rico municipal bonds, it was reducing it's trading desk inventory.  The AWC states:

On November 29, 2012, Santander began reducing its Puerto Rico municipal bond inventory.  (The December 13, 2012 Moody's downgrade) acceleranted the Firm's efforts to reduce its inventory of Puerto Rico municipal bonds, reflecting Santander's concerns about changed risks in the market for Puerto Rico municpial bonds and Santander's exposure to those risks.

The next day, on December 14, 2012, Santander closed its Puerto Rico trading desk to any new purchases of Puerto Rico municipal bonds... The Firm, however, continued to reduce its market exposure and entirely eliminated its inventory of Puerto Rico municipal bonds by October 2013.

... employees sold securities directly from their accounts to customer accounts.

Sanctions

FINRAs sanctions include:

  • A centure;
  • A fine of $2 million;
  • Restitution of approximately $4.3 million.

Analysis

The most significant finding in the AWC is that Santander failed to update it's risk-classification for Puerto Rico municipal bonds in the face of overwhelming evidence that the economy had been in a long-term decline, and the fact that the bonds had been downgraded a number of times.  (Puerto Rico GO bonds were downgraded on 8/8/11, 12/13/12, and 3/13/13.)

These increasing risks made the bonds less and less suitable for investors going back to the beginning of the economic decline in 2006.

The Accelerant Puerto Rico Municipal Bond Suitability Matrix

Accelerant has created a suitability matrix showing how Puerto Rico municipal bonds became more risky and less suitable over time.  It provides a framework for evaluating the suitability of client positions in Puerto Rico municipal bonds, by level of client account concentration. Key features:

  • Identifies three distinct phases of increasing risks in Puerto Rico municipal bonds;
  • Highlights two milestones where continuing to hold the bonds required higher risk tolerances or lower allocations;
  • Provides a clear and consistent method for evaluating damage claims.

For a high resolution version of the Suitability Matrix, go here.

The_Accelerant_Puerto_Rico_Changing_Suitability_Matrix

__________

For information about Puerto Rico municipal bonds expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

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Topics: municipal bond crisis, FINRA, closed-end funds, Puerto Rico, UBS, supervision, securities litigation, Compliance, Santander

UBS Hit with $34 Million in Fines over Puerto Rico Funds

Posted by Jack Duval

Sep 29, 2015 4:29:00 PM

UBS_Puerto_Rico

FINRA and the SEC just announced a $34 million fine against UBS for its Puerto Rico funds.  You can find the announcement here.

For the full AWC, see this.

We will have more analysis later.

__________

For information about Puerto Rico municipal bonds expert Jack Duval, click here.

For my previous coverage of the Puerto Rico municipal bond crisis, see this.

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Topics: municipal bond crisis, FINRA, closed-end funds, Puerto Rico, UBS, SEC, securities litigation

Accelerant Arbitration Market Indicator Flashes Highest Sell Signal Since 2000

Posted by Jack Duval

Nov 13, 2013 8:38:39 AM

The Accelerant Arbitration Market Indicator printed at 1.42, the highest since 2000.  

Two quick take-aways:


  1. For securities litigators: the lull in filings is probably in the ninth inning;

  2. For investors:  Caveat emptor.


You can also link to the visualization (which also has a comparison of the FINRA arbitration filings and the S&P 500) here.

 

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Topics: FINRA, Statistics, Data Analysis, litigation, investments, analytics, Accelerant Arbitration Market Indicator, FINRA Arbitration, Law Firm Analytics, Predictive Analytics

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