Massachusetts’ Secretary of the Commonwealth, William Galvin, is taking on Robinhood for violating Massachusetts’ new fiduciary duty rule for broker-dealers. In December 2020, Galvin filed a 24-page regulatory complaint, seeking to ban the popular trading app for violating the State’s strict fiduciary duty rule that requires broker-dealers to act in the best interest of their clients. Galvin raised three different violations against Robinhood that allegedly fell short of the new strict fiduciary standard. This new rule, passed in February 2020, was created in response to the Securities and Exchange Commission’s Regulation Best Interest (Reg BI), which Massachusetts believed did not go far enough. Reg BI bars brokers from putting their own financial interest above those of their clients, but fails to define what it means to act “in the customers’ best interest” or mandate that brokers recommend a single best product. While Reg BI requires the disclosure and mitigation of conflicts of interest, Massachusetts felt this requirement was also lacking. Galvin stated that Reg BI is “basically a souped-up version of the suitability standard,” and felt a new State rule was necessary to protect the growing crowd of young investors in the State. During this past year, due to COVID-19 and other meme-based investment activities on the application, Robinhood accumulated over 3 million new users in the first four months of 2020. Galvin’s concerns revolve around the 500,000 customers in Massachusetts, with accounts totaling over $1.6 billion.
The Allegations and Robinhood’s Response
Galvin claims that Robinhood fell short of acting in its clients’ best interest. The first allegation claims Robinhood’s technological outages compromised its clients and their assets through Robinhood’s failure to supervise and respond adequately to the disruptions. The second allegation claims Robinhood violated its own rules regarding options trading by approving customers to engage in the practice without having the necessary qualifications. Lastly, the third allegation claims Robinhood uses “gamification” to encourage unnecessary trading risks. Under this gamification allegation, Galvin asserts Robinhood’s promise of free stocks, push notifications and “signature digital confetti,” encourages “continuous and repeated engagement with its application.”
Robinhood responded to these allegations in the regulatory proceeding by filing suit in Massachusetts state court against the State of Massachusetts on April 15, 2021, to remove the matter from the administrative process. Robinhood’s representatives report that the company continues to work to ensure the system’s scale and its availability to its customer base. The company also disclaims the allegations that it targets an unsophisticated customer base, but rather believes its application provides customers with the proper tools to educate themselves and invest on their own.
Robinhood’s suit against the State claims the new fiduciary rule is invalid under state and federal law. First, Robinhood argues that federal law preempts this new rule, given the introduction of Reg BI. Secondly, under State law, Robinhood asserts that Massachusetts common law does not define brokerage firms as general-purpose fiduciaries to their customers and the Secretary’s actions to usurp the authority of the Judicial Branch is prohibited. Also under State law, Robinhood asserts that the new fiduciary rule does not apply to them as a “self-directed” brokerage firm, given they do not make investment recommendations or provide investment advice.
Upcoming Issues for the Court to Address
In this suit, the State court is going to need to resolve three different issues: preemption, enforcement power, and proper application. The court will need to determine if the SEC’s Reg BI preempted Massachusetts’ new rule. If the court decides the state law is not preempted, the court will then need to determine if the securities division has the authority to enforce this rule, given the states’ common law. Lastly, the court will need to determine if the rule encompasses Robinhood in its authority as a self-directed brokerage firm. This last question will revolve around the definition of “recommendation,” as Robinhood asserts in its complaint, “broker-dealers, as a matter of law, do not owe their customers general fiduciary duties, even when providing customers with investment advice and recommendations. Instead, under Massachusetts law, broker-dealers owe their customers fiduciary duties only when they act with discretion and make the investment decisions for their customers. Robinhood does neither of those things.” Robinhood currently provides a list of securities in various categories for customers to choose from in its application. There is a lot of debate regarding these lists and if they should qualify as providing investment advice. Barbra Roper, the Director of Investor Protection at the Consumer Federation of America, stated “We can’t tolerate a situation in which apps and digital platforms are able to do indirectly, through psychological nudges, what they would be prohibited from doing directly in the form of a recommendation.”
While this matter unfolds, Robinhood continues to deal with the oversight of its application with the uptrend in meme investing and an influx of customers who have been drawn to investing during a year of COVID-19 lockdown.
The combination of issues in this proceeding involving Reg BI preemption, what may constitute a recommendation, and the interplay of advancing technologies make the battle between Robinhood and Massachusetts one to watch closely over the months and years to come.