The Story of Robinhood and the Sheriff of Wall Street

As the GameStop battle between the Reddit community, r/WallStreetBets, and hedge funds continues, a new player has inserted itself into the game and attracted a lot of attention—Robinhood Markets, Inc. (“Robinhood”). My previous blog post gives an in-depth discussion about GameStop and how the current short squeeze developed. This post focuses upon Robinhood and its involvement in the ongoing controversy.

Robinhood is an investment and trading application which prides itself in offering commission-free trading and providing everyone with access to the financial markets, “not just the wealthy”. Robinhood launched its application in March 2015 and quickly garnered the attention of the millennial demographic, with 80% of its customer base averaging age 26. As such, Robinhood sought to be classified as the spokesperson for the individual investor, famously tweeting “[l]et the people trade.” But is that really true?

On January 28, 2021, following an effort by users of r/WallStreetBets to drive up the price of GameStop’s stock market, Robinhood suddenly restricted transactions for GameStop’s stock to position closing only. As a result of this restriction, retail investors could no longer buy shares or even find the stock in the App. The App had previously allowed the hedge funds to manipulate the market causing the price of GameStop’s stock to soar from a high of $490 in the morning to a low of $133 in the afternoon, before closing at $193 per share. This represented a loss of 44% from Wednesday’s closing price.

Robinhood later released a statement stating that transactions were restricted “[i]n light of recent volatility”. On the same day, Robinhood’s co-founder and co-Chief Executive Officer, Vladimir Tenev, appeared in an interview on CNN in an attempt to justify Robinhood’s decision for the restrictions, noting that Robinhood needed to comply with strict financial requirements set forth by the Securities and Exchange Commission (“SEC”).

The SEC—an independent agency of the U.S. government created by the Securities and Exchange Act of 1934—is primarily responsible for enforcing the federal securities laws, proposing securities rules, and regulating the securities industry. As such, the SEC regulates the conduct of broker-dealers and imposes a variety of requirements on them, such as antifraud provisions, regulation analyst certifications, additional regulations for trading by members of exchanges, brokers and dealers, and many more. It is only in very limited circumstances that the trading of stocks is to be restricted and listings of stocks removed or “delisted”. Some of the reasons include failing to meet minimum financial standards or violating regulations, for example, if there is evidence of fraud or if the company has failed to make material disclosures.

In the case of market volatility, however, a delisting or permanent restriction on trade is not normally imposed. Rather, the SEC has established certain safeguards for the protection of investors in case of a volatile market. These safeguards include the Limit Up-Limit Down Mechanism (“LULD”) and the Revised Market-Wide Circuit Breakers (“Circuit Breaker”). The LULD mechanism addresses market volatility by preventing trades in individual securities from occurring outside of a specified price band—usually, 5%, 10%, 20%, or the lesser of $.15 or 75%, depending on the price of the stock. This means that if a stock’s price spikes or dips and does not naturally move back within the price bands within 15 seconds, a five-minute trading pause may be imposed. Circuit Breakers are procedures which intend to curb panic-selling by imposing trading halts if a severe market price decline reaches levels that may exhaust market liquidity. These procedures may halt trading temporarily or, under extreme circumstances, close the markets before the normal close of the trading session.

Neither the LULD nor the Circuit Breakers mechanisms prescribe a permanent restriction on trading. It is also noteworthy, that these mechanisms do not distinguish between restrictions on the purchase and the sale of shares. If a temporary trading pause is implemented, it will ordinarily occur for all trades on a specific stock or market wide. Furthermore, a delisting is typically controlled by an exchange, such as the New York Stock Exchange (“NYSE”). Robinhood, however, is a securities brokerage and does not get to control the listing venue of a stock. Notably, the NYSE did not restrict or shut down GameStop’s listing despite the recent market volatility which Robinhood decried.

Robinhood, however, improperly acted as an exchange and “delisted” GameStop from its App, completely barring investors from purchasing shares for an entire day, before partially lifting the ban and allowing the purchase of up to five shares starting on January 29, 2021. Investors could continue to sell their shares without any restrictions. With the partial lifting of the restrictions, the price shot up to nearly $400 in the afternoon, when Robinhood once again decided to place a restriction and allow retail investors to only buy up to two shares. This caused the price to go back down again. Therefore, it does not appear that Robinhood was merely seeking to comply with SEC regulations and protect retail investors who use its application.

If these allegations are proven to be true, then it would appear that Robinhood has itself engaged in market manipulation in order to protect one of its major investors at the expense of its many smaller private investors. This is the central allegation of a new lawsuit filed in the U.S. District Court for the Southern District of New York. The markets are in uncharted territory. The securities are also in new territory. However, trading platforms should be aware of their potential exposure to market manipulation allegations when they control the investments of self-directed investors.