The regulatory and legal headwinds facing Robinhood

Robinhood Markets Inc, the online brokerage at the center of this year's retail trading frenzy, disclosed on Thursday previously unreported regulatory risks in its long-awaited initial public offering filing.

Amid an increasingly hostile climate in Democrat-led Washington, Robinhood's growing regulatory attention could be a turn off for some potential investors.

Aside from fines, Robinhood noted that government probes could result in business restrictions, increased compliance controls, changes to products and services and brand damage.

The company, which boasts 18 million customers, had drawn regulatory penalties for system outages and misleading disclosures even before it sparked outcry by curbing trading in some shares at the height of January's "meme stock" saga. 

That episode sparked multiple probes and intensified scrutiny of Robinhood's business model.

To date, the startup has paid more than $136 million to settle regulators' allegations of wrongdoing, including a $70 million penalty announced by the Financial Industry Regulatory Authority (FINRA) on Wednesday. 

While those penalties are small by Wall Street standards, Robinhood's legal expenses are growing fast, jumping from $1.4 million in 2019 to $105 million last year, the filings show.

Here are some of the regulatory threats that Robinhood noted in connection to its IPO.

'Meme Stock' Probes

Robinhood said that regulators had issued subpoenas or sought testimony and information from the company and CEO Vladimir Tenev as part of investigations into trading restrictions the brokerage imposed during January's meme-stock volatility.

The regulators included the US Attorney's Office for the Northern District of California, the Securities and Exchange Commission (SEC), FINRA, the New York Attorney General's Office, other state attorneys general, Congress and some state securities regulators.

Perhaps the biggest revelation, though, was that authorities also took the unusual step of seizing Tenev's cell phone, Robinhood said, without elaborating.

Other Investigations, Legal Risks

Robinhood also revealed what appeared to be a previously unreported probe by New York's Department of Financial Services (DYFS) focused on anti-money laundering and cybersecurity issues that the company expects to settle for around $15 million.

Additionally, in April, the California Attorney General's Office issued a subpoena seeking documents and information about Robinhood's trading platform, business and operations, and the application of California's commodities regulations to the platform. The company said it is co-operating with the probe.

Unrelated to the meme stock episode, the Massachusetts Securities Division (MSD) sued Robinhood in December alleging unethical and dishonest conduct and failure to act in accordance with its fiduciary duty among other lapses. Robinhood is fighting the suit.

The NYDFS, attorneys general for New York and California, and FINRA declined to comment. The SEC and MSD did not immediately respond to a request for comment.

The company is also the target of more than 50 private lawsuits related to January's trading restrictions and other issues.

New Regulations

Due to the meme stock saga, policymakers are scrutinizing practices core to Robinhood's business model, most notably payment-for-order-flow (PFOF), whereby brokers route retail orders to wholesale brokers in return for payment.

PFOF and other transaction rebates accounted for 75% of Robinhood's $959 million in 2020 revenues, Robinhood said.

SEC chair Gary Gensler has said PFOF raises conflict of interest and competition concerns, and he has asked staff to recommend new rules.

The agency is also examining "gamification," the use of game-like features to encourage trading, as well as other rules relating to liquidity and risk management.

New regulation in these areas could require "significant changes to our business model," Robinhood warned. Because its competitors are not as reliant on PFOF, heightened regulation of the practice "could have an outsize impact on our results," Robinhood said.