Robinhood has been one of the biggest winners of the pandemic as hordes of investors have flocked to the app for the free stock trading. The company's valuation has skyrocketed as it has picked up users by the millions. Even though it does not charge commissions for trades, Robinhood still earns revenues off of its customers' activities. However, the SEC has filed civil charges against Robinhood for its failure to fully disclose to its customers how it makes money. In the wake of the SEC charges, investors have also filed a lawsuit of their own against the brokerage.
 

Wall Street Pays Robinhood for Your Business

Robinhood is able to afford to offer free stock trading to its legions of customers because it receives money in other ways. Even though investors pay Robinhood nothing, other parties pay the broker for the trades. It is the trading companies that fill the other that are the ones paying. Large market makers such as Citadel and Susquehanna and other companies investors may have never heard of pay Robinhood large amounts of money for the broker to route them the orders. Market makers pay for investors' orders because they make money on balance trading with the customer order flow. Thus, they are willing to write checks to Robinhood to keep the orders coming. This is called payment for order flow.

Investors wanting to know if this practice is legal should know that it is, provided that the broker makes certain disclosures to its customers. Here, the SEC charged Robinhood with not disclosing to customers that it relied extensively on payment for order flow. While investors are very happy to get free stock trading, it comes with a catch. The market makers that fill their orders may not be giving them the most advantageous trade execution. This could cost investors more money than they saved through free commissions. After all, there is a reason why Wall Street firms pay Robinhood tens of millions of dollars each year for their orders. They make plenty of money off Robinhood customers. In the end, the market makers and Robinhood were profiting handsomely, often at the expense of the customer. In other words, there is a cost to stock trades being free at Robinhood.

Robinhood agreed to pay the SEC $65 million to settle the charges against it. The SEC claimed that investors were deprived of over $34 million through inferior trade executions. One of its penalties was that the broker needed to hire an outside consultant to monitor whether customers were receiving the best possible trade execution. This should help ensure that customers are being fairly treated when they place orders with Robinhood.
 

The Class Action Lawsuit Followed the SEC's Charges Against Robinhood

As is often the case after the SEC comes in and files charges against a broker, the customers will soon follow with their own lawsuit. Securities laws allow for them to sue civilly in the wake of government charges. Here, the investors are seeking a total of $65 million in damages from Robinhood.

The lawsuit alleges that market makers compensated for their payments to Robinhood by getting the money back from the customer through inferior executions. This is hardly a surprise as Robinhood's business practices were well-known. However, they did not make full disclosure to customers and have been accused of not looking out for their own customers when selling their volume.

This is far from the only legal matter in which Robinhood is involved. The company is the defendant in a series of lawsuits that stem from the massive outages that shut the system down entirely in February and March. Investors are seeking to be made whole from the losses that they suffered when the Robinhood's outage prevented them from selling stocks on a day that the markets were plummeting.

Robinhood is also being pursued by regulators in Massachusetts. There, the company is alleged to have aggressively marketed itself to customers without having built the infrastructure in place to handle its explosive growth. This has resulted in outages and delays for customers as they seek to place trades in a volatile market. The company has lost some of its shine as the major brokerages have matched Robinhood in offering commission-free trades. Nonetheless, Robinhood has earned fierce brand loyalty from its millennial customers who have gotten used to the interface and started free trading with the broker.