Is Robinhood safe for the average investor?

FINRA regulators are creating trouble for broker-dealers that treat investors unfairly. After Robinhood suspended trading for investors, but not powerful hedge funds, regulators started asking questions. Today, they are eyeing the recent GameStop versus Wall Street drama for evidence that Robinhood failed to follow FINRA rules.

What Does “Short Squeeze” Mean?

Members of the subreddit forum “Wall Street Bets” recently executed a “short squeeze” which cost certain hedge funds huge amounts of money. “Shorting” means to place a bet that certain stocks will decline in value. In this case, several major hedge funds placed a bet that GameStop shares would decrease in value. This strategy is always risky, and hedge fund managers should understand those risks.

The “squeeze” came when Redditors made a coordinated effort to purchase GameStop shares at the same time. As a result, GameStop shares increased 400% in value, and some hedge funds lost huge amounts of money. When the short squeeze took off, Robinhood made it impossible for individual investors to execute trades for GameStop shares, while certain hedge funds and institutional investors continued trading as usual. 

Did the Reddit Group “Wall Street Bets” Manipulate the Market? 

Robinhood is not the only player accused of manipulative tactics. Market manipulation is against SEC rules, and Wall Street Bets’ short squeeze has been compared to an illegal “pump-and-dump” scheme. In a pump-and-dump scheme, market manipulators spread a false rumor about a security to inflate or deflate its price. For instance, brokers might mislead investors with “insider information” that a penny stock is about to dramatically increase in value, only to sell their shares once the price goes up. Their duped investors, meanwhile, lose their money.

But when Redditors inflated the price of GameStop, they used publicly available information about hedge funds shorting GameStop stocks. There is no evidence that they attempted to mislead investors.

Regulators and lawmakers are more likely to focus on the problems associated with Robinhood’s treatment of individual investors. The trading app may have failed to follow existing FINRA regulations regarding communication with the public.

FINRA Rule 2210: Concerns Over Trading “Gamification”

FINRA Rule 2210 addresses how brokerages communicate with the public. Will Robinhood get in trouble with FINRA for their gamification of trading?

Increasingly, FINRA has turned their attention to “New digital platforms with interactive and ‘game-like’ features.” The 2021 Report on FINRA’s Examination and Risk Monitoring Program states that firms should ask themselves, “If your firm’s app platform design includes “game-like” aspects that are intended to influence customers…how does your firm address and disclose the potential risks?”

In a December 2020 complaint, the Massachusetts Securities Division describes the game-like features, such as confetti bursting on the screen when an investor makes a trade. When Robinhood rolled out a new cash management feature, they rewarded users who had daily interactions with the app with a higher spot on the waitlist. The complaint argues that these game-like features incentivize risky trading without informing investors about the potential for losses.

FINRA Rule 2090: Does Robinhood Know Their Customers?

As a broker-dealer, Robinhood is subject to FINRA Rule 2111. To determine if a trade is suitable, a broker-dealer has an obligation to “know their customers,” e.g., to know how much risk their customers can handle.

Robinhood displays lists of the most popular securities on the app, which regulators have compared to a recommendation from a broker. Those securities must be popular for a reason, right? Regulators are still deciding what constitutes a recommendation from an app-based broker-dealer, and it is unclear how long it will take for them to decide how FINRA rules and regulations apply.

Robinhood Suspended Trading for Investors. Is that Legal?

According to Robinhood, they stopped allowing investors to execute trades because they did not have enough cash on hand to settle their investor’s trades. Venture capitalists provided much of the $3.4 billion that Robinhood needed to fulfill orders.

It is widely speculated that Robinhood had a more nefarious motive for suspending trading. They may have chosen to simply stop hedge funds from losing any more money. In a letter to Robinhood, Senator Elizabeth Warren stated, “The public deserves a clear accounting of Robinhood’s relationships with large financial firms and the extent to which those relationships may be undermining its obligations to its customers.” She also asked if “Robinhood engaged in any discussions with Citadel,” a large financial firm, “prior to Robinhood reaching its decision to instate restrictions on trading for GameStop and other stocks.”

Besides protecting investors, the SEC also seeks to “maintain fair, orderly, and efficient markets.” Robinhood could face legal consequences if regulators can prove they had improper motivations to suspend trading. Otherwise, their user agreement includes the provision that they can restrict an investor’s ability to trade securities at any time.

That’s not the final word on Robinhood. Securities attorneys can argue that there are existing FINRA regulations in place that the digital broker-dealer conveniently ignores.

What Can I Do if Robinhood Did Not Disclose the Risks of Trading?

As a broker-dealer, Robinhood resolves disputes with investors through FINRA arbitration. Unfortunately, the chips are often stacked against investors. Talk to a securities attorney if you have concerns about your Robinhood investments. Fitapelli Kurta offers free case evaluations – don’t hesitate to call (877) 238-4175 or email info@fkesq.com

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