Robinhood case to test Massachusetts fiduciary rule

But an investor advocate praises the state for targeting conduct other than outright fraud

Massachusetts regulators took on a difficult case against Robinhood to debut the state’s strengthened investment advice standard for brokers, compliance lawyers said.

On Wednesday, Secretary of the Commonwealth William Galvin charged the rapidly growing online trading platform with violating the Massachusetts fiduciary rule that went into force in September. Under the regulation, brokers must make financial recommendations without regard to their own financial interests.

In its order, Massachusetts alleged that Robinhood targeted young people with little investment experience, used gamification strategies to entice them to make repeated trades, and failed to maintain the platform’s infrastructure, which led to frequent outages.

“These actions do not represent the behavior of a fiduciary and are inconsistent with the duty Robinhood owes Massachusetts investors,” the order states. “By instituting this proceeding, the Enforcement Section charges Robinhood with … falling far short of the fiduciary standard required of a broker-dealer registered in Massachusetts.”

But that assertion raises a novel question about when an online trading platform makes a recommendation, said Kurt Wolfe, a securities compliance attorney at Troutman Pepper.

“They didn’t bring an easy case,” Wolfe said. “They’ve gone for a tough one that’s going to stretch the bounds of the rule in Massachusetts. There are undoubtedly easier cases to bring if the Massachusetts Securities Division wants to lay down a marker.”

The case also puzzles Kevin Walsh, a partner at Groom Law Group. It’s not clear that network failures are a breach of fiduciary duty, and it could be argued that Robinhood is doing a good thing by catalyzing interest in investing among young people.

“It strikes me as an odd early case,” Walsh said. “What seems to be missing was any allegation that any of the behaviors Galvin’s highlighted caused harm. There’s got to be easier cases to bring if what you’re looking for is wins and changing behavior.”

Barbara Roper, director of investor protection at the Consumer Federation of America, praised Galvin for pursuing a case that centers on behavior that doesn’t meet the best interests of investors rather than clear-cut violations like stealing client money.

“I like the fact that it targets conduct that falls short of outright fraud,” Roper said. “If anyone can give meaning to this standard, it’s Galvin. They’re good at focusing on practices that are on the border between legitimate and illegitimate … [and showing] this is a step too far. That’s helpful for defining the boundaries.”

Massachusetts and other states advancing their own fiduciary regulations say they’ve acted because the Securities and Exchange Commission’s new broker standard — Regulation Best Interest — is too weak to curb broker conflicts.

The Massachusetts action against Robinhood may result in a test of whether state-level rules or Reg BI should govern brokers.

“It’s not outside the realm of possibility that this will be the case that results in a preemption challenge,” Wolfe said.

The SEC took its own action against Robinhood Thursday, announcing a $65 million settlement over charges that the online broker failed to give customers the best prices on their trades.

The attention from regulators suggests that Robinhood doesn’t have a compliance system that matches its online platform operations.

“The level of maturity of their risk and compliance has not kept up with their level of rapid growth,” said Peter Dugas, executive director of Capco, a global financial services firm. “It makes sense for them to nationalize their compliance infrastructure to gain efficiencies to ensure compliance on federal and state requirements.”

Arguments about regulatory bifurcation could come up in court.