Professor John Orcutt breaks down the legal issues surrounding stock trading service Robinhood, stemming from the subreddit WallStreetBets investing in Gamestop. Produced and Hosted by A. J. Kierstead
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Legal topics include investing, terms of service, stock trading, securities
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A. J. Kierstead:
Micro-investing application Robinhood has been thrust into the news around the GameStop investing debacle. Professor John Orcutt joins me to discuss. This is The Legal Impact, the weekly podcast presented by the University of New Hampshire, Franklin Pierce School of Law. Now accepting applications for J.D. graduate programs and online professional certificates.
A. J. Kierstead:
Learn more and apply at law.unh.edu. Opinions discussed are solely the opinions of the faculty or hosts, and do not constitute legal advice or necessarily represent the official views of the University of New Hampshire.
A. J. Kierstead:
So, John, Robinhood sells itself as democratizing investing, with allowing anyone with a smartphone to invest in stocks and partial stocks. This led to it being pivotal around the whole Game Stocks fiasco, which you talked about a couple of weeks ago. And I'll be sure to link the episode in the episode description. How much impact does a service like this have on the industry as a whole?
John Orcutt:
Well, industry as a whole, honestly, we're going to have to see. We'll see whether it has a long-term impact on the industry. I would expect that it would. Simply, because it does make investing easier. It eliminates a few hurdles for people to get involved with the stock market.
John Orcutt:
As a result, more people are investing, honestly. And I expect that's a trend that will continue for some period of time, unless people have such a bad experience from losing money that they decide to exit the market.
A. J. Kierstead:
Something that made Robinhood infamous with the online community, well beyond Reddit, was their shutting down of trading of GME, which is GameStop, and for selling some shares, which could have been like a caching of ... It takes time for the trades to actually go through.
A. J. Kierstead:
This led to Robinhood being disavowed by everyone from Elon Musk, to Barstool's David Portnoy, YouTuber Philip de Franco. What's the legality of a trading platform doing something like that?
John Orcutt:
Before we say they've been disavowed by everyone, they were able to raise a couple of billion dollars from investors very quickly, both in terms of their ability to deal with that original problem. They raised a billion dollars, which allowed them to reopen the trading. And I'll explain in a second, why they had to restrict trading. And then, I believe they were able to do another private round immediately after that.
John Orcutt:
At least from investors in Robinhood's perspective, I don't think that they're viewing this as, "Okay. Robinhood is now in big trouble, and they're going to have difficulties." I don't think that's been the case. And I think as well, their subscriptions have dramatically increased as well. As to ... Even with the problems that they had, their subscriptions have increased.
John Orcutt:
And they're still on schedule to do an initial public offering at some point in 2021. Their demise is ... I do not believe that's case at all. In fact, I think they're probably flourishing more now than ever.
A. J. Kierstead:
What's the legality of them shutting down trading on specific stocks like that though?
John Orcutt:
It's legal. And I'm going to say, I think it is ... I'm going to even say without the typical lawyer qualifications, I think it was a legal act for them to do. I know there's been some class-actions filed against them as a result of that. I'm not optimistic for the success of those class actions.
John Orcutt:
The reason that they did it is because of a very complex structure that involves the fact that Robinhood is not the party that actually executes the trades. They're the broker. Right? They're the ones that facilitates the trade. You could think of them as the gateway into the trade.
John Orcutt:
But the actual physical transfer where a seller says, "Here I am handing you," although it's not handing, it's sent electronically, but just so you understand, "I'm handing you my stock certificates." And buyers saying "Here, I'm handing you my cash."
John Orcutt:
Robinhood is not the one that does that transaction. It's a clearing house that does that transaction. And that clearing house has certain deposit requirements, which I'm happy to explain if you think that the listeners want to know why that's all going on. But they've got deposit requirements.
John Orcutt:
And the more volatile and risky the transactions that the clearing house is exchanging or is conducting, the greater the deposit that's required from the broker in order to do those transactions. As everything got crazy, GameStop suddenly became a very volatile stock. And as a result, the deposit requirements went up and Robinhood just did not have enough cash on hand in order to fulfill those deposits.
A. J. Kierstead:
There's like this confusing, ethical versus a realistic, "Do we have the money to complete these transactions," arguments that are going on at both sides of it. This is an extremely ... It turned into a real volatile situation where even Congress has been getting involved with it.
John Orcutt:
Yeah. And we can talk about Congress's role and the fact that they're involved. And I do think that some things will come out of it. I just ... Sometimes what happens when you look at a complicated story like this, people look at the wrong part of the story first.
John Orcutt:
There are parts of the story that are interesting, and that have some more questionable practices. The clearing house one is not one of them. And what's happening there ... Just very quickly, the clearing house is in the middle of those trades. It's the one that actually facilitates the transaction.
John Orcutt:
Because the transactions don't take place immediately, when you buy stock, you don't get the stock certificates immediately. You get stock certificates in two days. When you sell stock, you don't get the money immediately. You get the money in two days. And then, as well, when you buy stock, you don't have to come up with the money immediately. I don't deliver that money for two days.
John Orcutt:
There's a lot that can happen in two days. There's risk that's associated with those transactions. At the same time, there are somewhere close to 10 billion securities transactions that take place every single day. Oftentimes those transactions are part of a series of transactions. So, I sell my Apple stock. And then I take the proceeds from my Apple stock and I buy Cisco stock. And I sell another stock and I buy another stock.
John Orcutt:
And I've done all these transactions that are chained together. If you have a big player that starts to default, or a group of players that starts to default, you can have a chain reaction. Now, all of a sudden you've got defaults that are going through the entire system and you get systemic risk. This is what happened in 2008, when Lehman defaulted on its side of a bunch of transactions.
John Orcutt:
All of a sudden, we had systemic risk in the markets. That's bad. One of the ways that we protect against that is, clearing houses basically serve as guarantors of each side of the transaction. When buyer and seller are doing their deal, if one of them defaults, the clearing house will step in and take its role. As it gets more volatile, it gets more expensive to step in and take that role.
John Orcutt:
As a result, the clearing house requires the brokers that are asking it to do the transaction to put in place a higher deposit, if the clearing house is going to have to do the guarantee. They don't really want to do the guarantee. They look to the broker with the deposit, and they use that money in order to facilitate the transaction where someone has broken their side of the deal.
A. J. Kierstead:
It seems like on all sides, with everything that's gotten put into the public sphere, there's this drastic simplification of what's going on. For better or worse.
John Orcutt:
Of course. This is a really sophisticated, complicated story. And it's even the sort of story, if you bring in your average securities attorney or your average broker, they'll be like, "I don't really know how clearing house processes work." Or I don't know ... It's complicated.
John Orcutt:
And another ... Just sort of going back to real easy law stuff as to why it's permissible. If you go and look at your subscription agreement on Robinhood, which they post on their website ... Their agreement provides them, in two provisions very clearly, the ability to restrict trading at any time.
John Orcutt:
It's part of the contract. Now we could argue about whether that should be part of the contract or not, whether they should have that right, but it's actually in there. Every one of the people who has agreed to that, that was part of the right.
A. J. Kierstead:
What do you predict will happen going forward with these independent stock sharing companies? With regards to legislation or regulation, they seem to be low-hanging fruit, when we have a democratic-controlled federal government at this point for at least the next couple of years.
John Orcutt:
I think there are a couple of things that will probably come or could come out of this. One issue that is just potentially troubling, and this is an issue that's not limited to securities, securities brokers, is the mandatory arbitration.
John Orcutt:
To the extent that you do have a dispute as a customer, your ability to get to the courts in order to have your dispute heard is oftentimes limited by mandatory arbitration provisions. I think that's something that will be looked at.
John Orcutt:
The more important practice that I think will be looked at is going to be the payment for deal-flow practice that Robinhood uses, and then several other of these lower-cost retail brokers use, where they won't charge you a commission for trading. They're giving away what would appear to most customers to be a free service, which is not, in fact, a free service.
A. J. Kierstead:
This sounds just so much like every social media platform. Terms of service.
John Orcutt:
Yeah. Oftentimes, you get what you pay for. This is one where, if you're using a cut-rate service in order to ... Just it's the most ... I'm going to do an oversimplification here, but if you are undertaking a multi-billion dollar strategy, you may not want to use the most cut-rates service in order to undertake that multi-billion dollar strategy. I think that's just something that is ... That's probably not the best way to do it.
A. J. Kierstead:
There's a reason why there's still, even with these small stock trading applications and platforms out there, there's still a huge need for the larger financial institutions, with having impact on the stock market.
John Orcutt:
Oh, yeah. No, absolutely. Our whole security system and the way we regulate it has primarily been based on the idea of allowing retail investors, who probably are not capable most ... Although I'm sure that many of the Reddit army would push back on me on this, are not capable of valuing stock and coming up with a thoughtful, independent analysis as to what is a proper price to buy stock at.
John Orcutt:
Our system allows for retail investors to free-ride on the efforts of the large institutional investors and make the whole system safer. And that's where we start getting in things like efficient market theory. That's really what our system is based on. When I invest, I don't actually have to thoughtfully look at, in most cases, whether or not this is a good buy or not. The market has done it for me, and I free-ride on those efforts.
John Orcutt:
And when I say the market, it's largely big institutional investors. Now, at the same time, you can get groups of individuals that decide they want to break out of that system, which is what's happened with this Reddit army. They're operating sort of outside of that normal system, where they're both trying to take down hedge funds and take advantage as well of a speculative bubble.
John Orcutt:
Our regulatory is really not built to protect them. And since they've already gone through this ... What was it? Three weeks ago, two weeks ago? We saw the big run-up all the way up to, if I remember correctly, it was $483. And then, everything sort of settled back down. And it settled down into trading in the $40 to $50 a share range.
John Orcutt:
And then, yesterday it took off. And then, this morning it took off again. Now, it's back up to at least, I think the opening bid was somewhere around $160 a share. It shot up from about $40 a share earlier in the week, to about $160 now. Honestly, I don't know how you protect people who don't want to be protected.
A. J. Kierstead:
Thanks for listening to The Legal Impact presented by UNH Franklin Pierce School of Law. To help spread word about the show, please be sure to subscribe and comment on your favorite podcast platform, including Apple, Google, and Spotify.
