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Robinhood Recommendations - Rise of the Machines

Posted by Jack Duval

Feb 9, 2021 7:42:31 AM

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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

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