Since the Robinhood mobile trading app temporarily blocked its customers from buying stock in GameStop (GME), AMC (AMC) Entertainment, and 11 other companies last Thursday, it has been hit with at least 33 federal lawsuits across the country. Filed in 10 states, including California, Florida, Illinois, and New York, most seek class action status and allege violations of securities laws or consumer protection statutes.
Four securities law experts — a big-firm, defense-side litigator and three law professors — expressed widely divergent views about the suits’ viability. The diversity of their perspectives reflects, in part, our still murky understandings of precisely what led Robinhood Financial to take the controversial step.
Robinhood’s shocking action Thursday was the culmination of an unprecedented, snowballing, populist assault on hedge funds. A throng of anti-Wall Street, day traders — self-organized on social media and empowered by Robinhood’s commission-free app — were forcing artificial spikes in the prices of lackluster stocks that hedge funds were betting on going down. The price of GameStop, for instance — a chain of brick-and-mortar video game retailers struggling to stay relevant in a world where games are increasingly downloaded directly from the web — rose more than 1600% in January. But the sudden trading restrictions Robinhood imposed Thursday infuriated its customers and raised legal issues.
President of the New York Young Republican Club Gavin Wax speaks to press at a Re-Occupy Wall Street demonstration to protest actions related to GameStop in New York City, United States on January 31, 2021. (Photo by Tayfun Coskun/Anadolu Agency via Getty Images)
“I think Robinhood is in a difficult position here,” says James D. Cox, a securities law scholar at Duke University School of Law. Causing customers to “miss out on an opportunity to buy stock in a company that was maybe going up to $1000,” he says, is a serious issue. It raises questions about whether Robinhood met its duty to provide “fair, just and equitable” treatment to all customers.
“I’m hoping FINRA opens up an investigation here,” continues Cox, referring to the Financial Industry Regulatory Association, a non-governmental watchdog overseen by the Securities and Exchange Commission (SEC).
(In a statement Friday, the SEC pledged both “to monitor” the “extreme price volatility” of certain stocks and “to review” actions taken by brokers “that may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities.”)
In contrast, Joseph A. Grundfest, a professor at Stanford Law School and a former SEC commissioner, is skeptical of the suits that have been filed. “These aren’t the strongest complaints I’ve ever seen,” he says in an interview.
A Robinhood spokesperson did not return messages seeking comment on the suits. On Thursday the company said — in a blogpost and on Twitter — that it acted to avert financial stress caused by regulatory obligations.
“As a brokerage firm,” it said, “we have many financial requirements, including SEC net capital obligations and clearinghouse deposits. Some of these requirements fluctuate based on volatility in the markets and can be substantial in the current environment. These requirements exist to protect investors and the markets and we take our responsibilities to comply with them seriously, including through the measures we have taken today.”
Several other brokers also restricted trading in the same stocks on Thursday, including Webull Financial and TD Ameritrade (owned by Charles Schwab), citing similar reasons. (A handful of federal suits have been filed against those two firms as well.)
‘Sheriff of Nottingham’
The stakes are particularly high for Robinhood, however. In December it reportedly hired Goldman Sachs Group to lead preparations for an initial public offering. Any cloud of significant legal liability could dash or postpone those plans.
NEW YORK, NY - MAY 10: Co-founder and co-CEO of Robinhood Vladimir Tenev speaks onstage during TechCrunch Disrupt NY 2016 at Brooklyn Cruise Terminal on May 10, 2016 in New York City. (Photo by Noam Galai/Getty Images for TechCrunch)
At the very least, the company must now try to reverse some brand tarnishment among its core customer base, many of whom feel betrayed. As the company’s trade name suggests, it was founded to empower the little guy by “democratizing finance for all.” But many users now suspect — despite Robinhood’s forceful and categorical denials — that the company acted to placate big Wall Street players. For reasons laid out below, the prime suspect is the hedge fund Citadel, which is affiliated with Citadel Securities, one of Robinhood’s market makers and a major source of its revenue. (Both Citadel and Citadel Securities have also denied any role in Robinhood’s decisions to restrict trading.)
“The company should rebrand from ‘Robinhood’ to ‘Sheriff of Nottingham,’” quips the big-firm defense lawyer interviewed for this article, who is among those who thinks the litigation poses a threat to Robinhood. He notes that his son used Robinhood and has now pledged to shun it forever as a result of what happened Thursday. (The lawyer asked not to be identified, in case his firm is eventually drawn into the litigation.)
The big ‘short squeeze’
Though some of the facts leading up to the lawsuits are widely known, a partial recap is necessary to understand the key legal arguments on each side.
Robinhood was founded in 2013, and released its first mobile app in 2014. The firm’s ethos was epitomized in a March 2016 tweet: “Let the people trade.”
In 2015 it became the first broker to offer commission-free stock trading — a seismic industry event that eventually forced rivals to follow suit. In 2018 it added commission-free options trading.
In January of this year, armies of angry, young, anti-Wall Street types, congregating in online chatrooms and, especially, in the subreddit WallStreetBets, began mounting an assault on hedge-fund fat cats. They bought stock in struggling companies that funds like Melvin Capital and Citron Research were known to be shorting (i.e., betting on the price to go down). Their concerted buying forced those stocks’ prices to skyrocket. Among the stocks lifted were those of movie-theater company AMC Entertainment, hard hit by the pandemic, and GameStop, the video game retail chain.
GameStop, which was trading at less than $5 per share last August, closed Friday at $325, quintupling in value just last week.
Hedge fund Melvin Capital was caught in a “short squeeze” — i.e., as the stock price soared, the cost of its short position became too expensive to maintain. It unwound its positions, taking catastrophic losses. Last Monday, two other hedge funds came to its rescue, infusing it with $2.75 billion of capital. A tranche of that money from Steve Cohen’s Point72, but the bulk of it, $2 billion, came from — you guessed it — Citadel, the sister firm to Robinhood’s market-maker, Citadel Securities.
Steven Cohen, Chairman and CEO of Point72 Asset Management, speaks at the Milken Institute Global Conference in Beverly Hills, California, U.S., May 2, 2016. REUTERS/Lucy Nicholson
Citadel’s role created some very bad optics, as they say. The whole reason Robinhood is able to offer commission-free trades is that certain high-frequency trading firms, known as market-makers, are willing to pay it for sending trades its way — a practice known as “payment for order flow.” According to a 2018 Bloomberg report, such payments from a handful of market-makers accounted for 40% of Robinhood’s revenue, with the most lucrative payments coming from Citadel.
As GameStop stock resumed its ascent last week, other populist wannabes cheered the mob on. On Tuesday, Chamath Palihapitiya, CEO of Social Capital, tweeted that he’d bought GameStop call options that morning (a bet that the stock would rise further), while Elon Musk egged on the assault a few hours later, tweeting “Gamestonk!!”
On Thursday, Robinhood stopped customers from buying any stock in GameStop, AMC, BlackBerry (BB), Nokia (NOK), and nine others, although it permitted customers to sell shares they already held. Some saw the asymmetry of its intervention as proof that Robinhood was trying to help the short sellers, by driving prices down. On the other hand, to have blocked customers from selling existing holdings might have caused those customers more tangible losses — if the market went south — than the more theoretical, foregone gains that might result from forbidding new purchases.
In any event, with the limits in place, the price of GameStop plummeted on Thursday, closing the day at $193.60 after closing Wednesday at $347.51.
On Thursday afternoon, Robinhood pledged to allow purchases of the volatile stocks to resume the next day, Friday, but with severe limits. Initially, for instance, customers were permitted to buy an aggregate total of only five shares of GameStop, meaning that if they already held that many, they couldn’t buy any more. By early Friday afternoon Robinhood shrank the GameStop aggregate cap further — to a single share. Nevertheless, GameStop shares soared back up to $325.
Since then, at least 33 federal suits have been filed. (It’s hard to tally the state-court number, as they are spread across thousands of distinct county-level dockets, many of which do not provide online services.) The plaintiffs complain of lost opportunities to profit. Many suits allege violations of FINRA rule 5310.01, which provides that a broker “must make every effort to execute a marketable customer order that it receives fully and promptly.” Others allege market manipulation (a form of securities fraud), breach of fiduciary duty, and violations of state consumer protection statutes, including California’s Unfair Competition law and Illinois’s Consumer Fraud and Deceptive Business Practices Act.
Two potential hurdles to the suits are apparent on the face of Robinhood’s standard customer contract. First, every customer acknowledges (at ¶16) “that Robinhood may, in its discretion, prohibit or restrict the trading of securities.” Second, the contract contains an arbitration clause (¶38) in which the customer generally waives “the right to sue.”
But the arbitration clause, by its terms, appears not to apply to class actions, so nearly all the suits being filed can apparently proceed.
As for the first hurdle mentioned — the clause purporting to give Robinhood unbridled discretion to restrict trading — Cox and Langevoort are doubtful that would be decisive in these cases.
“The contract cannot protect certain conduct like [stock] manipulation, bad faith, etc., if that could be shown,” Langevoort says in an email. “I certainly would be interested in knowing who talked to whom, and when.”
Can you have manipulation if there’s no lying?
Stepping back from these particular lawsuits — and while we have the experts handy — maybe we should also explore a more basic question that some readers might be wondering about.
Aren’t all these suits backwards? Isn’t it the plaintiffs — the folks in the WallStreetBets chatroom — who are actually the ones doing the stock manipulation? Aren’t they the ones who are rather obviously manipulating a stock price upward without any regard to its true value? And aren’t they doing it just for the sheer joy of seeing rich people suffer? Is that really legal?
As to these questions, our experts were generally in agreement. Basically, it seems to be legal. Or, at least, there’s no good precedent for declaring it illegal.
“It’s very similar to exam questions I’ve been giving for years,” says Grundfest. “Can you have manipulation if there’s no lying?”
Since stock manipulation is a form of fraud, regulators have typically pursued it in the past only when there was lying. What has happened here doesn’t seem to have required any.
Says Grundfest: “Someone says, ‘Look, there’s huge short interests exposed here. I’m going to buy stock. Wouldn’t it be great if all of us did.’ ‘Yeah, great idea,’ someone else says. ‘I’m going to do that.’” So there’s not necessarily any lying.
“There’s also no specific agreement,” Grundfest continues. “No one even knows who the other people are! Cuddlybear8 writes a comment, and then KoalaZebra2 writes a response.
“There’s no precedent on point,” Grundfest concludes.
Weird, but that’s where we are.
Correction: In an earlier version of this article, the reporter did not notice that the Robinhood arbitration clause, by its terms, does not apply to class actions.
Roger Parloff is a regular contributor to Yahoo Finance and has also been published in Yahoo News, The New York Times, ProPublica, New York Magazine, and NewYorker.com, among others. He was formerly an editor-at-large at Fortune Magazine.
