Michell Pacheco

Associate Editor

Loyola University Chicago School of Law, JD 2022

On December 17, 2020, the Securities and Exchange Commission (“SEC”) charged Robinhood Financial, LLC (“Robinhood”) with material misrepresentation and misleading its users about its revenue sources, specifically Robinhood’s receipt of payments from certain principal trading firms for routing its customer orders to them. The SEC charges against Robinhood also relate to certain statements about the execution quality Robinhood achieved for its customers’ orders and Robinhood’s failure to satisfy its duty of best execution. Robinhood agreed to pay $65 million to settle the charges.

Background

Robinhood launched its retail brokerage business in 2015. By mid-2018, it was one of the largest retail broker-dealers in the United States. Between 2016 and October 2018, Robinhood grew its customer accounts from approximately one million to approximately six million, a 500% increase. One of Robinhood’s primary selling points is that it does not charge its customers trading commissions. However, although Robinhood’s services are “commission-free”, Robinhood’s customers received inferior execution prices between 2015 and 2018 compared to what they would have received from Robinhood’s competitors. These inferior prices were caused largely by the unusually high amounts Robinhood charged principal trading firms for the opportunity to obtain Robinhood’s customer order flow. These payments are generally referred to as “payment for order flow.”

Payment-for-order-flow incentive

From 2015 through September 2018, on its online FAQs page describing how it made money, Robinhood did not include receiving payments for order flow, its single largest revenue source. Robinhood also instructed its customer service representatives not to mention payment for order flow in responding to questions about Robinhood’s revenue sources.

Instead of sending customer orders to buy or sell equity securities directly to national exchanges, Robinhood, like other retail broker-dealers, routed its orders to other broker-dealers, often referred to as “principal trading firms”, to either execute those orders or route them to other markets. In other words, Robinhood took a user’s stock order and sold it to a larger trading firm that executed the trade.

Principal trading firms offer incentives to retail-brokers like Robinhood to send them order flow. One incentive is “payment for order flow”, which includes any monetary payment that results in compensation to a broker-dealer in return for the routing of customer orders. Since its inception, Robinhood has received payment for order flow in exchange for routing its customer orders to principal trading firms. SEC rules permit the receipt of payment for order flow by broker-dealers. However, such payments must not interfere with a broker-dealer’s effort to obtain the best execution. The routing of the order flow and description of all the terms of any such arrangements must also be disclosed in quarterly reports. As stated above, Robinhood failed to disclose that it was receiving such payments from principal trading firms in its answer to the “How Robinhood Makes Money” FAQ on its website.

Price improvement incentive

Another incentive that principal trading firms may provide to retail broker-dealers is “price improvement” on customer executions. According to the SEC, price improvement creates a financial benefit for the customer since the customer receives a better price than he or she would have received had the order been executed at the national best bid and offer (“NBBO”) on the public quotation feed. In practice, most retail broker-dealers obtain price improvement on the vast majority of customer orders sent to principal trading firms.

In its administrative order, the SEC stated that during negotiations between principal trading firms and Robinhood, certain principal trading firms told Robinhood that if it negotiated for higher payment for order flow revenue, there would be less money available for the principal trading firms to provide price improvement to Robinhood’s customers. SEC further stated that Robinhood explicitly offered to accept less price improvement for its customers than what the principal trading firms were offering in exchange for receiving a higher rate of payment for order flow for its own benefit.

Duty of best execution

Robinhood also falsely claimed that its execution quality matched or beat that of its competitors. Broker-dealers such as Robinhood owe their customers a duty of “best execution.” Best execution requires that a broker-dealer endeavor to execute customer orders on the most favorable terms reasonably available in the market under the circumstances. By the fall of 2018, Robinhood included in its FAQ online page that its “execution quality and speed matches or beats what’s found at other major brokerages,” which was untrue. From October 2016 through at least June 2019, a committee formed by Robinhood to monitor the prices at which the principal trading firms were executing Robinhood customer orders noticed that Robinhood did not obtain much price improvement on its customer orders in equity securities. Yet, Robinhood did not attempt to resolve this pressing issue. Instead, it chose to send its customer orders to whichever Wall Street firm paid it the biggest fees at the time, rather than the ones that offered customers the best trading prices.

SEC’s administrative order also stated 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.

Settlement agreement

Robinhood has agreed to a cease-and-desist order prohibiting it from violating the antifraud provisions of the Securities Act of 1933 and the recordkeeping provisions of the Securities Exchange Act of 1934, censuring it, and requiring it to pay a $65 million civil penalty. However, Robinhood has not admitted nor denied fault regarding the charges that the SEC brought against it. Robinhood also agreed to retain an independent consultant to review its policies and procedures relating to customer communications, payment for order flow, and best execution of customer orders and ensure that Robinhood effectively follows those policies and procedures.