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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.
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.
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".
To simplify, there are two criteria that must be met to satisfy FINRA's definition of a recommendation:
- A suggestion to transact, (the “call to action”); and,
- 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. (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.
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.
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. 
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.
Perhaps the social media technique most heavily used by Robinhood is that of gamification.
“Gamification” is the use of elements typical in game playing to encourage engagement with a product or service. The MA Complaint states that Robinhood:
(Used gamification) to encourage and entice continuous and repetitive use of its trading application.
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. (Emphasis added)
Robinhood’s “strategies designed to encourage and incentivize continuous and repeated engagement with its application” includes the following:
Robinhood’s Recommendation Engine
Robinhood sends push notifications to customers to encourage interaction with the application and trading.
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. (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.
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…
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.
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.
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:
- Call the number of trades for all accounts;
- Filter for accounts that have not traded since opening; and,
- 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.
 FINRA Notice to Members 01-23; Online Suitability; 2. Available at: https://www.finra.org/rules-guidance/notices/01-23; Accessed February 4, 2020.
 Id. FINRA use to be known as “NASD”.
 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.
 Id. at 9.
 Id. at 3.
 See Merriam-Webster; s.v. “gamification”. Available at: https://www.merriam-webster.com/dictionary/gamification; Accessed February 5, 2021. I am paraphrasing above.
 Id. at 2.
 Id. at 4.
 Id. at 13.
 Id. at 14.
To learn more about suitability and fiduciary expert Jack Duval, click here.