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Robinhood is now a party to the phenomenon it helped create. This week, the newly public company became a so-called meme stock, riding retail trader glee to riches after a disappointing market debut. The investing app was worth $46 billion at the close of trading on Friday, up around 60 percent from its valuation a week before.
It is perhaps the inevitable evolution of a market driven by forces unleashed by the popular, commission-free trading app. It is also a striking turnaround from six months ago, when Robinhood was the tool of choice for traders in the original meme stocks, like GameStop and AMC Entertainment. That role prompted congressional hearings, regulatory interest and a major federal lawsuit in Florida consolidating 50 class actions from thousands of aggrieved investors nationwide.
In complaints filed just before Robinhood’s initial public offering on July 29, the investors echoed the concerns raised by officials that the company’s business model is fundamentally problematic. Robinhood may be riding high now, but its legal troubles cast a shadow on its success, and threaten its grand ambition to “democratize finance for all.”
In Robinhood’s I.P.O. registration document, a description of the legal proceedings pending against the company filled seven pages.
Some of the issues relate to Robinhood’s actions in late January, when it abruptly limited trading for customers clamoring for meme stocks that were soaring as groups of small investors united on social media and squeezed the institutional players betting against the shares. Robinhood’s curb on trading during the frenzy hurt its customers and benefited its business associates, according to investors in the class action. They accuse the company of gross negligence and violations of antitrust and securities laws.
Robinhood’s counsel did not respond to a request for comment.
Robinhood said it had restricted trading in meme stocks to protect itself and customers, citing regulatory obligations to monitor and maintain capital requirements. The class action could reveal more about what motivated the company’s decisions. That may challenge Robinhood’s pitch that it’s a platform for “everything that you use your money for,” as Vlad Tenev, its chief executive, told The Associated Press last month.
Building customer trust is key to Robinhood’s expansion beyond fee-free trading into new business lines, muscling in on more established rivals’ turf and justifying its heady market capitalization.
Though the class action names many other financial businesses, like Citadel Securities, Charles Schwab, Melvin Capital Management and SoFi Securities, Robinhood is the main antagonist. It is a defendant in nearly all of the dozens of original actions, is facing almost all the claims and appears on nearly every page of the filings. The complaint calls Robinhood “a true amateur among institutional brokers.”
Investors taking part in the class action argue that Robinhood’s business model has a built-in conflict of interest. The company generates about 80 percent of its revenue from payment for order flow, which allows it to offer commission-free trading to users. In this arrangement, the broker sells customer orders to market-making firms (primarily Citadel Securities in Robinhood’s case) that execute the trades. Robinhood makes more from this practice than other brokers because its traders are more active.
Critics of payment for order flow, who include some lawmakers and regulators, say it presents a conflict for brokers who are paid by market makers but owe a fiduciary duty to customers. And because brokers make more money if customers trade more, the incentive is to “gamify” trading, which could be against the investors’ interests. (In March, Robinhood removed the digital confetti that celebrated trades in the app.)
There is “no question” the decision to limit trading during the January chaos harmed retail traders and cast doubt on Robinhood’s claims of leveling the playing field for the small investor against big institutions, said Marc Steinberg of Southern Methodist University’s law school, the author of “Rethinking Securities Law.” “The question is to what degree we are going to hold parties liable.”
These sorts of lawsuits are an important enforcement mechanism, forcing more transparency from companies, Mr. Steinberg said. The class action will take at least 18 months to resolve if it goes to trial, said Maurice Pessah, one of the lead lawyers for the plaintiffs. Robinhood has told the court that it will seek a dismissal.
The plaintiffs have not yet determined how much they are seeking in damages if they succeed. Regardless, Robinhood is accustomed to paying up and moving on.
In July, it was hit with the Financial Industry Regulatory Authority’s largest-ever penalty, $70 million, for service outages and the misleading of customers. Late last year, the Securities and Exchange Commission imposed a $65 million fine on the company for its failure to disclose “true costs” to customers. The S.E.C. has promised a report on January’s trading frenzy this summer, and warned that changes to how brokerage apps operate might follow.
Does it matter? So far, Robinhood’s enthused users don’t seem fazed. In the year to June, Robinhood more than doubled its funded user accounts, to 22.5 million, and tripled its assets under custody, to more than $100 billion.
On the day Robinhood’s shares began trading, Mr. Tenev told CNBC that “we’re optimizing for happy customers, and we’re optimizing for the long term.” Given the company’s unresolved legal issues, even the status that comes from being a meme stock may not be enough to put the past behind it.
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