Robinhood “Test Case” in Massachusetts Explores Brokerages’ Duties to Self-Directed Customers

On April 15, 2021, the Massachusetts Securities Division (Division) brought a revised administrative action against online brokerage firm Robinhood Financial LLC (Robinhood) moving to revoke Robinhood’s state broker-dealer license. This action came on the heels of Robinhood filing a lawsuit and emergency motion in Massachusetts state court seeking declaratory and injunctive relief against the Division and William F. Galvin, Secretary of the Commonwealth.

In what Robinhood refers to as a “test case” regarding a new fiduciary rule in Massachusetts (MA Fiduciary Rule), the outcome could directly affect the company’s 500,000 in-state customers, and have wide-ranging significance as to the duties brokerages owe to self-directed investors.

Regulatory Background

Robinhood’s battle with Massachusetts became widely publicized after the Division filed an administrative complaint against the broker-dealer on December 16, 2020 (December 2020 Complaint). In the December 2020 Complaint, Robinhood was accused of violating the Massachusetts Uniform Securities Act by “aggressively marketing itself to Massachusetts investors without regard for the best interests of its customers and failing to maintain the infrastructure and procedures necessary to meet the demands of its rapidly growing customer base.”

This action stemmed from the recently adopted MA Fiduciary Rule, implementing a standard of conduct applicable to broker-dealers and agents in Massachusetts. The MA Fiduciary Rule imposes a fiduciary duty when providing customers with investment advice or recommending an investment strategy. A fiduciary duty also applies to the opening of or transferring of assets to any type of account, or the purchase, sale, or exchange of any security. The MA Fiduciary Rule became effective on March 6, 2020 and the Division began enforcing it as of September 1, 2020.

The MA Fiduciary Rule’s adoption in Massachusetts was largely due to the Division’s reaction against the U.S. Securities and Exchange Commission’s (SEC) recently promulgated Regulation Best Interest (Reg BI), which the Division viewed as not being protective enough of investors. The MA Fiduciary Rule imposes a higher level of duty to investors in Massachusetts than does Reg BI. Among the differences between the two regulatory regimes, the MA Fiduciary Rule explicitly applies a fiduciary standard to brokers, mandating that they not take their own financial interests into account when dealing with customers.

This increased level of duty in Massachusetts, according to some commentary, “will add further confusion for broker-dealers trying to determine the applicable standard of conduct for transactions with retail customers.” As Robinhood also argues in its court filings, the MA Fiduciary Rule is preempted by federal law, including the National Securities Markets Improvement Act of 1996. This last point is especially important, as Nevada, New Jersey, and Maryland have also considered more rigorous standards for broker-dealers.

The December 2020 Enforcement Action

The December 2020 Complaint, filed only a few months after the Division began enforcing the MA Fiduciary Rule, alleged several violations by Robinhood. These included “1) aggressive tactics to attract new, often inexperienced, investors; 2) failure to implement policies and procedures reasonably designed to prevent and respond to outages and disruptions on its trading platform; 3) use of strategies such as gamification to encourage and entice continuous and repetitive use of its trading application; 4) failure to follow its own written supervisory procedures regarding the approval of options trading; and 5) breach of the fiduciary conduct standard required by the Act and Regulations.”

The April 2021 Enforcement Action and Robinhood’s Response

Escalating matters further, the Division’s second and most recent administrative complaint against Robinhood, filed on April 15, 2021 (April 2021 Complaint), builds on the December 2020 Complaint and seeks the revocation of Robinhood’s license to conduct broker-dealer activities in Massachusetts. The April 2021 Complaint follows the recent controversy related to Robinhood’s and other online brokerages’ sudden halting of trading in GameStop and other “meme stocks” in January 2021. The Division now claims, according to a recent report, that Robinhood “continues to entice and induce inexperienced customers into risky trading” and demonstrates a “cavalier approach to complying with the duties it owes to Massachusetts customers.”

Robinhood’s contemporaneous lawsuit and motion seeking injunctive relief argue, in turn, that the MA Fiduciary Rule is invalid on its face and as applied to the broker-dealer. Robinhood points out that the SEC’s Reg BI does not impose a universal fiduciary standard on brokerages to the extent that the MA Fiduciary Rule does, and that the “Supremacy Clause of the U.S. Constitution prohibits the Secretary from preventing Massachusetts investors from choosing an option that the SEC purposefully preserved for investors nationwide.” Furthermore, Robinhood claims that the MA Fiduciary Rule is inapplicable to the company because it is a self-directed brokerage “that does not make investment recommendations or provide investment advice.”

Implications Going Forward

It remains to be seen how the court will rule on Robinhood’s lawsuit and motion, and whether or not the Division will revoke Robinhood’s license. While these matters involve Massachusetts law and would not directly affect other state securities laws, a court ruling against Robinhood’s challenge to the MA Fiduciary Rule (notwithstanding any likely appeals) would embolden other states’ efforts to impose a broad fiduciary duty on broker-dealers. Such state-level measures, of course, would only lead to widespread pushback and further litigation brought by the brokerage industry, and potentially result in a “patchwork quilt” of regulatory standards from state to state.

The attorneys at Giarrusso Law Group LLC have considerable experience with issues unique to the financial services industry, including SEC, FINRA, and state-level rules and regulatory developments. If you have a question regarding this recent announcement or any other regulatory matter, you may contact us at (201) 771-1115 or info@gialawgroup.com for a no-cost, confidential consultation.