Robinhood: A Modern-Day Outlaw
by Alexandros A. Papantoniou, PAPANTONIOU & PAPANTONIOU LLC
For many centuries, the English folk tale of a bandit dressed in a green gown with a red hood armed with a bow and arrows has been a parent’s go-to bedtime story for their children. Depicted as a hero by some and an outlaw by others, Robin Hood is remembered as a man stealing from the rich to give to the poor. The Modern-Day Robinhood, however, strives to change the tale. No longer Robin Hood will be remembered as a legendary outlaw stealing from the rich to provide for the poor, but rather an online brokerage platform preventing the less fortunate from becoming a tiny bit richer and the wealthy from losing billions.
Chapter I: The Setup
Until very recently, GameStop was merely known as an American retailer giant specialising in video games, consumer electronics and gaming merchandise.[i] Indeed, recent data indicate that GameStop is the world’s largest video game retailer operating more than 5,500 retail stores across the globe.[ii] In a pandemic-free parallel universe one might have expected the company to be thriving, yet the dramatic effects of the Covid-19 crisis on retailers were not any different for GameStop. The company was facing immense fixed and operational costs generated by the operation of 5,500 retail stores but strict national lockdowns prevented consumers from physically visiting the stores. GameStop, like the majority of the retail industry, struggled to successfully move its business online and thus found itself on the verge of financial distress.
And who doesn’t love financially distressed companies more than hedge funds? Hedge funds are financial partnerships that use a pool of funds gathered from accredited (sophisticated) investors and employ a variety of strategies to generate active returns for their investors. Relaxed oversight and regulation means that hedge funds have great leeway to invest aggressively and in a variety of financial products than most mutual funds and usually rely on volatility arbitrage, merger arbitrage and long-short equity strategies to generate returns for their investors.[iii] The majority of hedge funds employ a “2 and 20 compensation structure” meaning that hedge fund managers are paid a 2% commission of the assets they are managing and 20% of profits above a certain benchmark.
Hedge fund love for financially distressed companies stems from their ability to use “short-selling” strategies to capitalise on the troubles of such companies. In simple terms, if hedge funds believe that the price of a stock will tank, they will take a short position by ‘placing a bet’ on the declining fortunes of that company. This entails the hedge fund borrowing shares at their current price from brokers and selling them on even though they do not actually own them. If the stock indeed falls, the hedge fund buys back the stocks from the market at a lower price than that borrowed thus making a profit of the company’s falling stock price.
Chapter II: The Complicating Action
At least one Hedge fund, Melvin Capital, was shorting GameStop (or ‘GME’ as its stock acronym) and the army of r/WallStreetBets (hereinafter ‘WSB’) on the social platform known as Reddit, publicly devised a plan on the forum that would soon give hedge funds a ‘taste of their own medicine’. WSB is a sub-reddit (forum) made up of amateur retail investors engaging in daily investment discussions and opinionate on various investment decisions. This army of Redditors united to buy and hold masses of GameStop stock to combat GME short-selling and save the company. This evidently resulted in a dramatic increase in price. Indeed, in the beginning of January, GME was trading at around $18. By the end of January, it reached more than $380. This activity created a “short squeeze”. A short squeeze occurs when a stock price rises dramatically forcing short-sellers (i.e. Melvin Capital and other hedge funds who were betting that GME stock will continue to fall) to buy back the stock to close out (cover) their position to minimise their losses. Consequently, hedge funds short-selling GME stock were left with millions of dollars in stocks they had bought at a high price which they then had to offload at an even higher price accruing massive losses in the process. Indeed, financial analysts suggest that short-sellers lost more than $23.6 billion on GME this month.[iv]
There is no doubt as to the legality of short-selling strategies. Hedge funds have been engaging in short-selling for years. Although in the eyes of some, it is unethical, unjust, unfair or merely cruel to profit on the misfortunes of someone else, this is simply how Wall Street works. Therefore, although frowned upon, short-selling is entirely legal. However, to enjoy the fruits of short-selling hedge funds have to equally deal with the associated amplified risk. When investors buy stocks (i.e. ‘go long’) they stand to lose only the money they have invested. In contrast, when hedge funds short-sell, they can theoretically lose an infinite amount of money since there is no cap in stock price increases. Therefore, if more individuals buy GME stock, the price continues to surge thus, GameStop short-sellers continue to lose.
Chapter III: The Development
In a classic tale, WSB’s heroic unified effort to attack short-selling hedge funds would set the scene for a happy ending. Yet, Robinhood stepped in with the plot twist. Robinhood is an online brokerage firm and its customers place securities trades through the firm’s website by using a web-based application. Robinhood markets itself as a commission-free investing platform with the soon to be illustrated ironic slogan, “investing for everyone.”[v] Indeed, on 23 March 2016, Robinhood twitted “let the people trade” but have since disregarded their mantra and have blocked access for millions of its customers to trade particular securities.[vi] WSB users frequently relied on Robinhood for their investment decisions but Robinhood dubiously decided to forbit retail investors from trading GME and other shorted stocks while hedge funds were freely able to trade.
On 16 December 2020, Robinhood faced charges from the Secretary of the Commonwealth of Massachusetts over its “gamification strategy and options trading.”[vii] Essentially, Robinhood engaged in gamification strategies including, inter alia, sending daily push notifications and congratulating users after each trade. According to the complaint, such strategies were directed towards luring consumers into persistent participation and consistent engagement with the trading platform which in turn, generated greater revenues for Robinhood.[viii] Although gamification strategies are frequently used by companies to attract consumers and ensure persistent engagement, Robinhood’s tactics could be seen as “addictive and manipulative.”[ix] Conversely, gamification strategies by Fitness or Wellness Web-based applications are not frowned upon since they aim at positively influencing consumers. Nevertheless, Robinhood’s gamification strategies encourage frequent trading which may lead to severe losses for investors given that daily push notifications or offers, for example, have the propensity to lead to “quick decisions driven by emotions.”[x]
Chapter IV: Climax
Fast forward one and a half months later, Robinhood faces backlash over blocking any GME trading on its platform. A class action filed on 28 January 2021 against Robinhood in the New York District Court suggested argues that investors were deprived of potential gains on GME further stock price increases by pulling the stock from their web-based application. Analytically, the plaintiffs submitted the following:
“Robinhood, in order to slow the growth of GME and deprive their customers of the ability to use their service, abruptly, purposefully, wilfully, and knowingly pulled GME from their app. Meaning, retail investors could no longer buy or even search for GME on Robinhood’s app. Upon information and belief, Robinhood’s actions were done purposefully and knowingly to manipulate the market for the benefit of people and financial institutions who were not Robinhood’s customers.”
The Complaint rests on four causes of action namely: (i) breach of contract; (ii) breach of implied covenant of good faith and fair dealing; (iii) negligence; and (iv) breach of fiduciary duty. In relation to the first cause of action, the complaint suggests that:
“Robinhood breached its Customer Agreement by, among other things, failing to disclose that its platform was going to randomly pull a profitable stock from its platform; that Robinhood failed to provide adequate explanation to their customers; that Robinhood knowingly put their customers at a disadvantage compared to customers who used other trading apps; that Robinhood failed to provide access to its own financial incentives to pull certain securities including GME; that Robinhood’s prohibited plaintiffs from performing in a timely manner (or at all) under the contract; that Robinhood failed to comply with all applicable legal, regulatory, and licensing requirements; and that Robinhood failed to exercise trades and actions requested by customers.”
In relation to the second cause of action, the complaint submits that:
“Robinhood unfairly interfered with the rights of Plaintiffs and members of the Class and Subclass to receive the benefits of the Customer Agreement by, among other things, (i) failing to provide services necessary to carry out a trade; (ii) failing to provide certain trading services whatsoever; (iii) failing to inform individuals in a timely member of the drastic changes in trading abilities; and (iv) prohibiting plaintiffs from buying GME for Robinhood’s own pecuniary interest and not disclosing those interest to Plaintiffs and all Class and Subclass members.”
The complaint raises as a third cause of action negligence on behalf of Robinhood on the basis that the online brokerage had a duty to exercise reasonable care in providing services to its customers. Specifically, the complaint argues that:
“Robinhood unlawfully breached its duties by, among other things, (i) removed GME without notice from its trading app; (ii) failed to provide financial services related to GME; (iii) failing to notify customers in a timely manner of the GME “blackout.”
In furtherance of their arguments, the members of the class action submit that Robinhood’s conduct fell far below of the standards expected from online brokerage platforms. Analytically, the complainants argue that:
“Robinhood’s conduct as set forth in this Complaint was want of even scant care, and its acts and omissions were and continue to be an extreme departure from the ordinary standard of conduct. Their actions breach any duty of care to their customers, but are also inconsistent with the standard of care expected from similar firms in the open market. Upon information and belief, no institutions similar to Robinhood has ever outright banned customers from purchasing a specific share of a specific security. Robinhood essentially abandoned its customers altogether by pulling GME, a standard of care so far below what is required for a business engaging in time sensitive trading services that it amounts to a complete abandonment of its duties. Robinhood’s grossly negligent and wrongful breaches of its duties owed to Plaintiffs and members of the Class and Subclass proximately caused losses and damages that would not have occurred but for Robinhood’s gross breach of its duty of due care. These losses reflect damages to Plaintiffs and members of the Class and Subclass in an amount to be determined at trial or separate proceedings as necessary.”
The final cause of action raised by the complainants is breach of fiduciary duty owed by Robinhood to customers as a licensed provider of financial services. The complaints submitted that:
“Robinhood breached its fiduciary duties to Plaintiff and Class members by, among other things, failing to disclose that its platform was going to remove GME purchases in a timely manner; actually removing GME; removing GME for its own pecuniary benefits; that Robinhood failed to provide access to its financial services in a timely manner; that Robinhood failed to comply with all applicable legal, regulatory, and licensing requirements; and that Robinhood failed to exercise trades and actions requested by customers in a complete and timely manner (also required by FINRA Rule 5310).”
Prima facie, the complainants seem to have built an ironclad case against Robinhood. Yet, upon close examination of the Robinhood Customer Agreement, the complaint arguably rests on unstable foundations. The Customer Agreement affords Robinhood a broad range of powers to limit, restrict or even completely block trading all at its discretion. Indeed, Article 16 of the Customer Agreement clearly states that:
“… Robinhood may, in its discretion, prohibit or restrict the trading of securities, or the substitution of securities in any of My Accounts. I understand that Robinhood may execute all orders by Me on any exchange or market, unless I specifically instruct Robinhood to the contrary. In the event of a breach or default by Me under this Agreement, Robinhood shall have all rights and remedies available to a secured creditor under all applicable laws and in addition to the rights and remedies provided herein. I understand that Robinhood may at any time, at its sole discretion and without prior notice to Me: (i) prohibit or restrict My access to the use of the App or the Website or related services and My ability to trade, (ii) refuse to accept any of My transactions, (iii) refuse to execute any of My transactions, or (iv) terminate My Account. The closing of My Account will not affect the rights or obligations of either party incurred prior to the date My Account is closed.”[xi]
Consequently, the issue to be determined by the New York District Court is whether Robinhood can rely on express terms agreed by customers upon the commencement of their trading activities on the platform to essentially dictate the course of trading on specific financial products. In the eyes of the general public, this may be regarded as an act analogous to market manipulation. This is mainly because Robinhood’s decision to restrict GME trading prevented the further accumulation of losses to short-selling hedge funds. It is therefore, entirely plausible for one to draw the conclusion that ironically and in stark contrast to its namesake, Robinhood prevented retail investors from capitalising on the strategy of hedge funds to short-sell GME stock thus effectively, deciding to steal from the poor and give to the rich.
legalistic point of view, interested parties are set to embark on a long,
burdensome and complicated trial. One might expect principles of contract,
financial and tort law to clash with principles of fairness, justice and
equality. Some may side with the view that Robinhood adopted a
“self-preservation mechanism” and accept that “Wall Street will always change the rules in order to
survive.”[xii] Yet, it will be up
to the judiciary to decide the lifespan of Wall Street’s immunity.
[i] ‘United States Securities And Exchange Commission Report’ (Sec.gov, 2016) https://www.sec.gov/Archives/edgar/data/1326380/000132638016000320/a10k-fy15q4.htm
[ii] ‘United States Securities And Exchange Commission Report’ (Sec.gov, 2020) https://www.sec.gov/ix?doc=%2FArchives%2Fedgar%2Fdata%2F1326380%2F000132638020000022%2Fa10k-fy19q4.htm
[iii] ‘What Are Hedge Funds?’ (Investopedia) https://www.investopedia.com/articles/investing/102113/what-are-hedge-funds.asp
[iv] ‘Gamestop? Reddit? Explaining What’s Happening In The Stock Market’ (NBC News, 2021) https://www.nbcnews.com/business/business-news/gamestop-reddit-explainer-what-s-happening-stock-market-n1255922
[vi] Brendon Nelson v Robinhood LLC – Class Action Complaint  (United States District Court Southern District Of New York).
[vii] ‘Administrative Complaint Secretary Of The Commonwealth Of Massachusetts’ (Sec.state.ma.us, 2020) https://www.sec.state.ma.us/sct/current/sctrobinhood/MSD-Robinhood-Financial-LLC-Complaint-E-2020-0047.pdf
[ix] ‘Robinhood Adds Market Manipulation And Gamification To A Quiver Of Woes’ (Investmentnews.com, 2021) https://www.investmentnews.com/robinhood-adds-market-manipulation-and-gamification-to-a-quiver-of-woes-202128
[xi] ‘Robinhood Customer Agreement’ (Cdn.robinhood.com) https://cdn.robinhood.com/assets/robinhood/legal/Robinhood%20Customer%20Agreement%20(June%2022)%20(1).pdf