Robinhood: Success, Legal Battles, and Outlook

Posted on by Matthew Ender-Silberman

This blog post examines Robinhood’s successful business model, two of its legal battles, and its outlook.

A New and Successful Investing Model

Launched on Apple’s App Store in December 2014, Robinhood makes it easy for its investors to trade.1 Signing up for a Robinhood account on its simple app takes five minutes or less.2 Moreover, the brokerage firm does not charge a commission for trading, and it does not have account minimums.3 There is also a social aspect: users receive a free share of stock if they refer the app to their friends, and the app shows users the most popular stocks on the platform.4

By offering these services, Robinhood’s mission is to “democratize finance for all.”5 Robinhood’s business model has certainly attracted many investors. The company announced in May 2020 that it served over 13 million users.6

Robinhood can afford to offer its users these perks, despite charging zero commission fees, because it derives profit via other means. One revenue source comes from Robinhood Gold, a subscription service that allows subscribers to take advantage of more features than users of the free model.7 These features include the ability to trade on margin and access to better market data.8 The main source of the company’s revenue, however, comes from a practice called payment for order flow (“PFOF”).9 By engaging in PFOF, Robinhood directs its users’ trade orders to high frequency traders (“HFTs”) who execute these trades.10 In exchange for the ability to execute these trades, HFTs send Robinhood money.11 This PFOF model creates significant revenue: during the first three quarters of 2020, for example, Robinhood made $466 million through PFOF.12

Due to Robinhood’s popularity and profit model, the brokerage firm is valued in the billions. Indeed, the company was valued at $7.6 billion in July 2019.13 Partially in response to Robinhood’s success, Charles Schwab, TD Ameritrade, and E-Trade all began to offer commission-free trading in October 2019.14

Despite the fact that some competitors have adopted its business model, Robinhood continues to enjoy increasing valuations. In fact, in February 2021, Rainmaker Securities data on Robinhood’s private stock indicated that the company was being valued at around $40 billion.15

Legal Battles

However, the very innovations that make Robinhood so profitable have also caused legal issues for the company. In December 2020, an SEC investigation found that Robinhood gave its customers worse execution prices than its competitors gave their customers, in part because of its PFOF model.16 The SEC found that

“Between October 2016 and June 2019, certain Robinhood orders lost a total of approximately $34.1 million in price improvement compared to the price improvement they would have received had they been placed at competing retail broker-dealers, even after netting the approximately $5-per-order commission costs those brokers-dealers were charging at the time.”17 Robinhood lost these price improvements for its customers in part because the brokerage firm negotiated agreements with market makers that gave Robinhood a higher percentage of the profits from its PFOF than the industry standard.18 Indeed, the industry standard gives 80% of the PFOF surplus to the customers, while the remaining 20% goes to the firm; Robinhood, however, contracted to give its customers only 20% of its PFOF surplus, keeping the other 80% for itself.19

The SEC also found that Robinhood did not adequately disclose to its customers that the firm used PFOF. The SEC’s order told the story of how Robinhood failed to disclose to—and at points intentionally misled— its users about the company’s use of PFOF. To illustrate the point, the SEC found that at various points from late 2016 to 2018, Robinhood did not mention PFOF as a revenue source on its answer to “How Robinhood Makes Money” on its FAQ page.20 Moreover, the SEC found that Robinhood told its customer service representatives to “avoid” mentioning PFOF as a revenue source in their conversations with users.21 As a result, the SEC charged Robinhood with violating Sections 17(a)(2)-(3) of the Securities Act and Section 17(a) of the Exchange Act22 In response, Robinhood agreed to settle for a $65 million fine, without admitting to or denying the charges.23

Regulatory scrutiny does not end there. During the same month, Massachusetts regulators filed a complaint against Robinhood for violating a newly passed state law that has stricter fiduciary duties for broker-dealers than the federal standard.24  The complaint alleges that Robinhood violated the law in part because the app’s infrastructure could not withstand the number of users it served.25 The complaint further alleges that Robinhood’s platform experienced up to 70 “outages or disruptions” from January 1, 2020 through November 30, 2020.26 For example, the complaint alleges that Robinhood’s platform was largely inaccessible on March 2, 2020, the largest gaining day for the Dow Jones Industrial Average up until that point.27

The complaint also alleges that Robinhood engages in “gamification,” making the app feel like a game to its users.28 By doing so, the regulators allege that Robinhood entices its customers to increase the number of trades they execute, to their detriment.29 According to the complaint, these techniques include: confetti popping on the screen every time a user makes a trade, offers of up to $500 to invest in free stocks to users that refer friends, daily push notifications sent to users to encourage using the app, and push notifications that send users to a list of the most popular stocks traded on the app.30 The complaint goes on to cite that 241 Massachusetts customers with “no investment experience” executed an average of five trades per day from December 1, 2017 to the date of the complaint.31

Outlook

We must wait to see how the courts rule on this issue, especially considering how this litigation marks the first time that Massachusetts regulators have attempted to enforce the new stricter fiduciary duties for broker-dealers.32 If the courts find Robinhood violated its fiduciary duty, Robinhood would need to invest more heavily on its app infrastructure to ensure that outages do not continue, and it would need to curb its gamification techniques. While stopping outages will be a good thing for its business, changing its gamification techniques might have negative consequences for its business model. Indeed, the fewer trades that its customers execute, the less Robinhood can profit from PFOF. Moreover, while Massachusetts is the only state that has such a strict broker-dealer fiduciary duty on the books, other states might follow suit.33 If that were to happen down the line, the result of this litigation could have consequences for Robinhood that extend to other states, as well.

  1. Daniel Huang, Young, Poor and Looking to Invest? Robinhood Is the App for That, Wall Street J. (Jan. 6, 2015, 1:01 PM), https://www.wsj.com/articles/BL-MBB-31486. ↩

  2. John Divine, How Robinhood Changed an Industry, U.S. News & World Rep. (Oct. 17, 2019, 3:33 PM), https://money.usnews.com/investing/investing-101/articles/how-robinhood-changed-an-industry. ↩

  3. Id. ↩

  4. Id. ↩

  5. Our Mission, Robinhood, https://robinhood.com/us/en/support/articles/our-mission/ (last visited Apr. 7, 2021). ↩

  6. Nathaniel Popper, Robinhood Has Lured Young Traders, Sometimes With Devastating Results, N.Y. Times (Feb. 2, 2021), https://www.nytimes.com/2020/07/08/technology/robinhood-risky-trading.html. ↩

  7. How Robinhood Makes Money, Robinhood, https://robinhood.com/us/en/support/articles/how-robinhood-makes-money/ (last visited Apr. 7, 2021). ↩

  8. Upgrading to Gold, Robinhood, https://robinhood.com/us/en/support/articles/upgrading-to-gold/ (last visited Apr. 7, 2021. ↩

  9. Order Instituting Administrative and Cease-and-Desist Proceedings Against Robinhood Financial, LLC, Exchange Act Release No. 10906, 7 (Dec. 17, 2020), https://www.sec.gov/litigation/admin/2020/33-10906.pdf. ↩

  10. John Detrixhe, Fintech firms like SoFi and Robinhood offer “free” stock trading. What’s the catch?, Quartz (Mar. 1, 2019), https://qz.com/1560010/is-sofi-invests-brokerage-service-really-free/. ↩

  11. Id. ↩

  12. Dave Michaels & Alexander Osipovich, Robinhood Financial to Pay §65 Million to Settle SEC Probe,Wall Street J. (Dec. 17, 2020, 6:46 PM), https://www.wsj.com/articles/robinhood-to-pay-65-million-to-settle-sec-probe-11608213680. ↩

  13. Kate Rooney, Robinhood lands a $7.6 billion valuation after recent funding round, CNBC (Jul. 22, 2019, 1:23 PM), https://www.cnbc.com/2019/07/22/robinhood-lands-a-7point6-billion-valuation-after-recent-funding-round.html. ↩

  14. Peter Talbot, 3 Online Brokers Cut Commissions to Zero As Free Trading Edges Toward the Norm, NPR (Oct. 1, 2019, 3:21 PM), https://www.npr.org/2019/10/01/766110889/schwab-cuts-commissions-to-zero-as-free-trading-edges-toward-the-norm. ↩

  15. John Detrixhe, Robinhood shares are soaring just like the stocks that trade Robinhood, Quartz (Feb. 11, 2021), https://qz.com/1971633/robinhood-pre-ipo-secondary-shares-signal-40-billion-valuation/. ↩

  16. Order Instituting Administrative and Cease-and-Desist Proceedings Against Robinhood Financial, LLC, supra note 9, at 2. ↩

  17. Order Instituting Administrative and Cease-and-Desist Proceedings Against Robinhood Financial, LLC, supra note 9, at 10. ↩

  18. Order Instituting Administrative and Cease-and-Desist Proceedings Against Robinhood Financial, LLC, supra note 9, at 6. ↩

  19. Order Instituting Administrative and Cease-and-Desist Proceedings Against Robinhood Financial, LLC, supra note 9, at 6. ↩

  20. Order Instituting Administrative and Cease-and-Desist Proceedings Against Robinhood Financial, LLC, supra note 9, at 7. ↩

  21. Order Instituting Administrative and Cease-and-Desist Proceedings Against Robinhood Financial, LLC, supra note 9, at 9. ↩

  22. Order Instituting Administrative and Cease-and-Desist Proceedings Against Robinhood Financial, LLC supra note 9, at 3. ↩

  23. Order Instituting Administrative and Cease-and-Desist Proceedings Against Robinhood Financial, LLC supra note 9, at 1, 15. ↩

  24. Administrative Complaint, Robinhood Financial, LLC E-2020-0047, 1 (Dec. 16, 2020), https://www.sec.state.ma.us/sct/current/sctrobinhood/MSD-Robinhood-Financial-LLC-Complaint-E-2020-0047.pdf. ↩

  25. Id. at 3-4. ↩

  26. Id. at 10. ↩

  27. Id. ↩

  28. Id. at 12-14. ↩

  29. Id. at 14. ↩

  30. Id. at 12-14. ↩

  31. Id. at 14. ↩

  32. Caitlin McCabe, Massachusetts Regulators File Complaint Against Robinhood, Wall Street J. (Dec. 16, 2020, 4:20 PM), https://www.wsj.com/articles/massachusetts-regulators-to-file-complaint-against-robinhood-11608120003. ↩

  33. Massachusetts Promulgates Broker-Dealer Fiduciary Rule, Sidley Austin (Mar. 4, 2020), https://www.sidley.com/en/insights/newsupdates/2020/03/massachusetts-promulgates-broker-dealer-fiduciary-rule. ↩

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