FINRA Is Bearish On FinTech (For Now) With Its Record Fine Against Robinhood

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I am certain that, by now, you have read the Robinhood AWC.  Here is a fascinating take on that settlement, and what it portends for the securities industry, as well as for FINRA, by Denise. – Alan

There’s no question that FinTech firms are on the rise, and attempting to revolutionize the financial services space for the better. One such FinTech firm is none other than the notorious Robinhood. A technology company at heart, but a broker-dealer by definition, Robinhood wants its users to take trading into their own hands (or should I say smartphones?). While it’s true that more Americans are turning to the self-directed, commission-free trading model via FinTech apps, this sometimes comes at a cost, too. On June 30, 2021, FINRA announced that it reached an AWC with Robinhood, imposing a $70 million record-breaking monetary sanction against the FinTech firm. Although FINRA cited various violations of its rules, ultimately, its message to the industry goes beyond Robinhood’s underlying misconduct: FINRA is bearish on FinTech – at least for now.

FINRA acknowledges that FinTech is alive and well, even providing a loose definition of the term in a footnote (“FinTech refers to new uses of financial technology”). Yet, FINRA hasn’t quite fully accepted the FinTech brokerage model. As Jessica Hopper, FINRA’s Head of the Department of Enforcement, said, “compliance with these rules is not optional and cannot be sacrificed for the sake of innovation or a willingness to ‘break things’ and fix them later.” As a further testament to that, FINRA, through its findings in the AWC, concluded that Robinhood relied too extensively on its automation to conduct its brokerage operations, and did not conduct adequate supervision over its technology-based brokerage model. While Robinhood may want to revolutionize the financial markets, FINRA wants to continue regulating them in the way it knows how. In furtherance of this point, here are some of the key findings from the AWC.

False and Misleading Information Distributed to Customers.

FINRA found that Robinhood made various false and misleading communications to its customers, including misinformation regarding its “Free Stock” program, inaccurate cash balances and buying power, and the ability to place trades on margin, among other things. Although FINRA took issue with the misleading communications, it also brought up the corollary issue that no firm principals supervised those communications. Specifically, FINRA found that “Robinhood did not establish reasonable procedures to supervise the accuracy of the account information it displayed to customers via its website and mobile applications,” and further explained that “the firm relied on mathematical models and formulas to calculate much of the data it displayed to customers, but it did not require that a supervisory principal review the accuracy of those models and formulas.” Yet, this is only one of FINRA’s many findings that focus on the fact that Robinhood failed to employ firm personnel to supervise critical brokerage operations. Apparently, not all regulatory requirements can be outsourced to “new uses of financial technology” as FINRA sees it.

Failure to Exercise Due Diligence Before Approving Options Accounts.

This is one of the more interesting findings in the AWC. The issue here is that FINRA Rule 2360(b)(16) requires that either a Registered Options Principal or a General Securities Sales Supervisor (i.e., a person) approve a customer account for options trading, so Robinhood’s almost entirely automated system cannot satisfy the rule’s requirements. As a workaround to this rule, Robinhood employed some firm principals to review options account approvals. In reality, though, FINRA found that the FinTech giant was approving customer options accounts based almost entirely on its computer algorithms with very limited principal review (“Although Robinhood’s algorithms currently approve hundreds of thousands of options applications every month the firm’s team of principals previously reviewed only 20 applications per week; in May 2021 the firm increased its principals’ review to approximately 500 applications per week.”) As FINRA stated, “Robinhood used an almost entirely automated system for approving customers for the two levels of options trading offered by the firm.” It seems that by largely automating its options account opening process, Robinhood chose to ask FINRA for forgiveness rather than permission.

Failure to Supervise Technology Critical to Providing Customers with Core Broker-Dealer Services.

FINRA also drew an important distinction between brokerage operations and broker-dealer oversight when it found that Robinhood (the broker-dealer) failed to supervise the activities of its parent company, Robinhood Markets Inc. (RHM), which is responsible for operating and maintaining technology related to its brokerage operations. Specifically, FINRA found that:

From January 2018 to February 2021, Robinhood failed to reasonably supervise the operation and maintenance of its technology, which, as a FinTech firm, Robinhood relies upon to deliver core functions, including accepting and executing customer orders. Instead, Robinhood outsourced the operation and maintenance of its technology to its parent company, Robinhood Markets, Inc. (RHM)—which is not a FINRA member firm—without broker-dealer oversight. Robinhood experienced a series of outages and critical systems failures between 2018 and late 2020, which, in turn, prevented Robinhood from providing its customers with basic broker-dealer services, such as order entry and execution.

FINRA’s mandate is clear: Robinhood – as a regulated, broker-dealer entity – must adequately oversee its brokerage operations and ensure compliance with FINRA rules, even if those core brokerage activities are conducted through technology-driven processes by its parent company. While FINRA didn’t mind that Robinhood outsourced its operations to its parent company, it did take issue with the fact that Robinhood failed to oversee those operations. This distinction is important in the way that FinTech firms must learn to balance both their business and regulated sides. So, while Robinhood may have passed its brokerage operations off to its parent company so it can be the fun technology company it wants to be, ultimately FINRA reminds us that Robinhood cannot avoid its role as a boring, old, regulated broker-dealer entity.

Failure to Have a Reasonably Designed Customer Identification Program.

In another consequential finding, FINRA determined that Robinhood did not have a reasonably designed customer identification program in violation of its AML rules. FINRA’s main concern here was the fact that Robinhood delegated most of its account opening processes to algorithms “without any effort to verify that the information provided by the customers was accurate.” Here, FINRA set an expectation that FinTech firms should engage in some type of “manual review” conducted by personnel in order to ensure compliance with its AML rules. This is what FINRA had to say about it:

Robinhood failed to establish or maintain a customer identification program that was appropriate for the firm’s size and business.” The firm approved more than 5.5 million new customer accounts during that period, relying on a customer identification system that was largely automated and suffered from flaws.

FINRA also raised the fact Robinhood did not have any employees whose primary job responsibilities related to its customer identification program during the period, and that a single principal approved more than half of the more than 5.5 million new accounts that were opened. These findings reinforce the AWC’s principal theme: an automated brokerage model cannot run on its own without meaningful human oversight.

In all, these AWC findings, along with the others, formed the basis for the largest fine ever issued against a broker-dealer. FINRA’s award against Robinhood is monumental, and not just because of it is record-breaking amount, but also because it establishes a new regulatory precedent for FinTech firms to follow.

Still, it seems that the real winner here at the end of the day is: Robinhood. Just one day after the AWC was entered against it, Robinhood filed for its IPO under the catchy ticker, “HOOD,” showing its playing power in this industry. With over 31 million users and counting, Robinhood isn’t going anywhere anytime soon.

The question remains: Will it be FINRA that decides to update its rules to adapt to the rise of FinTech or will FinTech firms need to continue accommodating their operations until FINRA catches up with the trend? While it may be the latter for now, my prediction is that FINRA will eventually have no choice but to accept the rise of FinTech as more investors are choosing this financial path. In the end, it may be FINRA that needs to adapt to the FinTech model instead of the other way around – and FINRA may find itself bullish on FinTech after all.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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