Robinhood’s Cautionary Tale Of Piling Into ‘Meme Stocks’ Results In Big Losses, Customer Complaints And Lawsuits

Robinhood, the stock trading app marketed to novice investors as the democratization of Wall Street and leveling the playing field, is now the subject of dozens of lawsuits.

Its ethos was to empower Gen-Z and Millennials to invest and trade stocks, as a means of building wealth for themselves. In an era of massive wealth inequality, Robinhood positioned itself as the way to help younger people catch up financially and build their future fortunes. The company made its app intuitive and easy to use—somewhat akin to a video game. It wasn’t your dad’s stodgy Charles Schwab brokerage account.

The app would offer lists of the most purchased stocks. It could be seen as a guide or a thinly veiled wink and a nod to pile into certain stocks, which would propel them higher. The newbie traders would see quick profits, propelling them to buy even more stocks. This is a precursor to what later occurred on a massive level.

Seemingly out of nowhere, the r/WallstreetBets subreddit, which now has roughly 7 million members, touted stocks that they believed would “go to the moon,” along with locker-room banter and excessive rocketship emojis. They particularly focused on story stocks that were the subject of hedge funds that were selling the shares in the companies short. This practice, while legal, is a way that big-money investors can profit from the misery when stock prices crater, which could ultimately drive companies into bankruptcy.

The hedge funds borrow stock, then sell it. They hope the stock price plummets, as the plan is to later buy it back at a bargain basement price—the difference would be their profit. When the hedge fund covers their positions, this calls for buying back stock. Some savvy Redditors figured out that if they bought shares in GameStop and AMC Entertainment that had large short holdings, they could force the hedge funds to buy more stock, sending the price spiraling higher. Sure enough, it worked for a while and a number of day traders made a lot of money. Some made hundreds of thousands of dollars and a few made millions.

Unfortunately, the tables turned. As volume boomed on the app, Robinhood restricted the purchases of the “meme stocks,” like GameStop, AMC, BlackBerry, Bed Bath & Beyond and Nokia. The restrictions stemmed the buying and these stocks collapsed in value.

Investors were irate. The anger—over what seemed at the time was a capricious decision to benefit some rich hedge funds to the disadvantage of the average investor—was exemplified in the outrage expressed in a viral video made by Barstool Sports founder Dave Portnoy, who became a big proponent of day trading during the pandemic.

Senator Elizabeth Warren was incensed over the recent trading activities and said in a CNN interview that the stock market “is a rigged game.” Warren boldly called out the Securities and Exchange Commission, the premiere Wall Street regulator, admonishing the agency “to grow a backbone” and “get off their duffs and do their jobs.” The senator demanded an investigation into possible cases of market manipulation—on the part of both social media crowdsourced stock tips and hedge fund short selling.

According to the Washington Times, “House Financial Services Committee Chair Maxine Waters said her committee would dig into the conduct of hedge funds and private funds, in the aftermath of market volatility surrounding Robinhood’s decision to prevent its users from buying certain stocks.”

Robinhood is now being sued because of the restrictions it put into place. Investors allege that it violated the company’s own terms and conditions. According to the Verge, “About 30 parties across 10 states have sued the company in federal court, many seeking class action status. They allege that Robinhood users lost millions of dollars because they were unable to buy  during the freeze, and that the company chose to “manipulate the market” to help other financial institutions.”

Vlad Tenev, the CEO of Robinhood, went on a number of cable news shows to explain what happened and was harshly grilled by his interviewers. The first round of interviews enraged his  customers, as Tenev did not offer what sounded like any solid reasoning for the drastic measure that cost investors millions—if not billions—of dollars in losses.

Tenev’s messaging changed, as it was reported that the company raised over $3 billion to shore up its financial situation. Connecting the dots, it seemed that there was a call for Robinhood to increase its net capital to avoid any regulatory problems, as the meme stock and options trading was incredibly volatile and could have put the company at great risk.

Eventually Tenev, in a corporate posting, open to the public, attempted to offer a better explanation for his decision to stop accepting buy orders in the selected stocks. He seemed to blame the restriction on Wall Street regulations, including the way securities are settled, saying, “It’s time for T+2 to go.” The chief executive added, “Last week, we saw the impact the two-day trade settlement period has on investors and ultimately the entire American financial system. Clearinghouse deposit requirements skyrocketed overnight. People were unable to buy some of the securities they wanted. Investors were angry and concerned, an unintended byproduct of the antiquated settlement process.”

Tenev pointed out that his company was on the hook for putting up a large amount of money, due to regulatory and clearinghouse rules. “The amount required by clearinghouses to cover the settlement period of some securities rose tremendously this week. How much? To put it in perspective, this week alone, our clearinghouse-mandated deposit requirements related to equities increased ten-fold. And that’s what led us to put temporary buying restrictions in place on a small number of securities that the clearinghouses had raised their deposit requirements on,” he wrote on the blog posting.

Tenev added, “It was not because we wanted to stop people from buying these stocks. We did this because the required amount we had to deposit with the clearinghouse was so large—with individual volatile securities accounting for hundreds of millions of dollars in deposit requirements—that we had to take steps to limit buying in those volatile securities to ensure we could comfortably meet our requirements.”

He offered additional insights into the situation, stating, “Many of you have questions about decisions Robinhood made last week, and what you can expect from the firm going forward. There is a lot of confusing information out there, and while we have tried to provide clarity as best we can, we want you to hear directly from us. Simply put, Robinhood limited buying in volatile securities to ensure it complied with deposit regulations. We posted an in-depth explanation on our blog on Friday, and we hope you’ll take a look at it.”

On Tuesday, the story stocks were crushed again causing continued losses. This may inspire further lawsuits and amplify the ones in progress.

This is a cautionary tale for investors. It’s easy to get caught up in the euphoria of a good story, such as the one spun as the “good, young guys vs. the evil hedge fund short sellers.” Although the story may be entertaining, it doesn’t mean it’s a good investment and a lot of money could be lost.

Source: Forbes

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