Regulators slam Robinhood for targeting newbie investors with aggressive marketing

New York(CNN Business) Robinhood has lured inexperienced investors to its free-trading app with gaming elements such as colorful confetti and other aggressive marketing techniques, Massachusetts securities regulators alleged Wednesday.

The 24-page complaint accuses Millennial-focused Robinhood of violating state law and regulations by failing to take steps to protect its customers and failing to safeguard its system from the explosive growth that led to dozens of outages and disruptions in 2020.

Robinhood used strategies "such as gamification to encourage and entice continuous and repetitive use of its trading application," the enforcement arm of the Massachusetts Securities Division said, referring to elements of game playing designed to boost user activity.

In a statement, Robinhood said it disagrees with the allegations in the complaint and plans to "vigorously" defend itself. The startup pointed to improvements made to its options offering, additional safeguards and enhanced educational materials.

"Millions of people have made their first investments through Robinhood, and we remain continuously focused on serving them," the company said. "Robinhood is a self-directed broker-dealer and we do not make investment recommendations."

Massachusetts regulators are seeking a range of sanctions on Robinhood, including fines, an independent review of the platform and compensation to investors who have been harmed.

The trading app has emerged as one of the winners of the pandemic. Robinhood added 3 million funded accounts between January and April alone, rapid growth of 30%. The startup has completely disrupted the online brokerage industry, and its private-market valuation has surged to $11.2 billion.

"Robinhood used advertising and marketing techniques that targeted younger individuals...with little, if any, investment experience," the Massachusetts regulators said.

There's no doubt that Robinhood's free-trading business model has boosted access to financial markets among first-time investors. That can increase the number of Americans have exposure to market booms, such as the current one.

One newbie investor made 12,700 trades in six months

However, recent events have also drawn attention to the potential dangers of giving new investors easy access to exotic financial instruments typically used by sophisticated market players.

In June, the family of a 20-year-old student said he died by suicide after confusion over an apparent negative balance of $730,000 on his Robinhood account. The student was using Robinhood to trade options and his family believed he was misled by the app's interface.

Robinhood's co-founders said they were "personally devastated by this tragedy" and announced a series of changes to its options offering and user interface in response.

The Massachusetts complaint said Robinhood "relentlessly bombards" users with gamification strategies, including "colorful confetti raining down" on their screens after executing trades.

Regulators also pointed to how Robinhood rewarded customers who interacted daily with the app by moving them up on a waitlist for a new product, a cash management feature.

The complaint took issue with how frequently newbie investors traded, suggesting the app being used by some more for short-term trading than long-term investing.

For instance, regulators found at least 670 Robinhood customers with limited or no investing experience who averaged at least five trades per day. And in one example, a customer with no previous experience was able to make more than 12,700 trades in just six months.

'Plagued' by outages

At the same time, Robinhood's system has buckled under the strain of the trading boom.

Between January 1 and the end of November, Robinhood experienced as many as 70 outages or disruptions on its trading platform, according to the complaint. One such outage took place on March 3, preventing some Robinhood users from participating on a day when the S&P 500 gained a staggering $1.1 trillion in value. Robinhood was "plagued by outages or disruptions" every single month in 2020, the complaint said.

Robinhood "knew or should have known" its infrastructure was "incapable of supporting its rapidly expanding customer base," regulators said.

In its statement, Robinhood defended efforts to bolster its system.

"Over the past several months," the company said, "we've worked diligently to ensure our systems scale and are available when people need them."