January 2021 saw a historic event in the global financial market unfold: a head-to-head clash between retail investors and hedge funds. The chronology of events is as follows: hedge funds announced their positions of ‘shorting’ GameStop stock in light of the company’s recent surge in stock prices. Shorting is the act of betting against a company’s performance, meaning that if the share price falls, investors make a profit. Accepting this announcement as a challenge, droves of retail investors bought GameStop shares to inflict heavy damages on hedge funds while simultaneously reaping profit from the stock’s higher valuation.
This battle ultimately led to a shake-up of the financial markets as the long-standing hegemony of hedge funds was directly challenged. The share prices of GameStop appreciated by more than 1000%, which resulted in hedge funds that had shorted the stock being met with astronomical losses. Most notably, a multi-billion dollar investment firm, Melvin Capital Management LP, saw losses of 53% of its total capital due to GameStop stock appreciation.
On January 28th a turning point was seen when a popular brokerage firm, Robinhood, blocked its customers from buying further shares of GameStop during the height of its rapid appreciation. Following this action, the share prices of GameStop fell from $347.51 on the previous day’s closing to $193.60. In response, 33 federal lawsuits were launched against Robinhood with many claiming lost opportunities to profit. This article will examine the validity of this claim as well as the likelihood of such lawsuits being accepted in court, through the lens of the Common Law.
What is Robinhood?
Robinhood is a brokerage firm that was founded by two Stanford graduates in 2013, with the mission of “democratising finance for all”. Its founders, Vlad Tenev and Baiju Bhatt, were inspired by the Occupy Wall Street movement and had created the app to increase accessibility for retail investors and to level the playing field in investment. Its selling points are that it does not charge transaction fees unlike other brokerage firms and has a simple yet appealing User Interface (UI) in its mobile app. Due to these features, the firm has achieved meteoric success as seen from recording 13 million registered accounts at the end of 2019 versus competing brokerage firms such as Schwab’s 12.7 million and E-Trade’s 5.5 million accounts. Despite this, Robinhood has faced criticism regarding its business model of “payment for order flow” which means that its revenue is dependent on Wall Street firms who pay for orders from Robinhood clients that are then directed to them. As a middleman who keeps a symbiotic relationship with firms that had a stake in shorting GamesStop, many believe that Robinhood had motive to prevent further appreciation of GameStop share prices.
Cases of financial harms at Common Law
The main argument for those pursuing lawsuits against Robinhood is that of the right to damages for a loss of chance after a breach of contract. They claim that Robinhood’s blocking of the option to buy further GameStop shares have resulted in either inability to purchase shares that had a high propensity to appreciate and/or the depreciation of the shares due to panic selling by existing holders of GameStop shares.
The leading authority on recovery for the loss of a mere chance of obtaining benefit is Chaplin v Hicks where the plaintiff was wrongfully deprived of a chance to proceed to the subsequent round of a beauty competition. While the trial judge initially refused to accept the case stating that it was impossible to tell whether or not she would have won, the Court of Appeal differed in opinion. The CA held that it was necessary to decide on the plaintiff’s chance of success in the competition and compensate proportional damages based on that chance.
When applied to the current case, there are parallels which bolster the strength of the lawsuits against Robinhood. While it is impossible to conclusively determine that holders of GameStop shares would have made a profit amidst the market volatility, the deprivation of their chance to realise gains due to Robinhood’s actions could be sufficient in the eyes of the Common Law to seek compensation.
One key distinction between Chaplin v Hicks and the Robinhood case is the presence of breach of contract. While the former case involved a breach of contract by the contest manager, Robinhood narrowly evades this condition through its standard customer contract. In Clause 16 of the aforementioned contract, the customer is made to acknowledge “that Robinhood may, in its discretion, prohibit or restrict the trading of securities”. Therefore, even if it is accepted that Robinhood’s action of blocking the purchase option had contributed to a loss of chance to gain, its conduct might not amount to breach of contract, thereby weakening the argument based on Chaplin v Hicks.
However, some argue that Clause 16 will not be able to offer Robinhood bulletproof protection. Professor Langevoort and Professor Cox from Georgetown and Duke University respectively, suggest that the “contract cannot protect certain conduct like manipulation, bad faith, etc...” Although contingent on whether Robinhood’s action can be shown to fall under these examples, it seems then that there remains hope for aggrieved investors.
Robinhood’s official explanation for its actions on the 28th of January is as follows:
“As a brokerage firm, 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.”
Upon closer inspection, Robinhood explains its actions on the basis of a process known as “clearing”. Clearing is the action of reconciling the purchases and sales for accounting purposes. In short, Robinhood alleges that it faced a legitimate risk from the extreme volatility of the GameStop share price. If investors who had purchased GameStop shares ended up defaulting due to high fluctuations before clearing was completed, Robinhood would have had to bear the costs of default. It is very likely that this defence will be used by Robinhood in justifying the blocking of further purchases.
The result of the lawsuit will ultimately be dependent on whether Robinhood’s actions can be shown to have been in bad faith. The US Securities and Exchange Commission (SEC) have announced that it will review restrictions imposed by Robinhood to see if it “disadvantage[d] investors or otherwise unduly inhibit[ed] their ability to trade certain securities.” For a conclusive resolution of this incident, the findings by the SEC will no doubt be pivotal.