Rob Yellen
D&O and Fiduciary Liability Product Leader, FINEX, Willis Towers Watson

Rob is a recognized expert in directors and officers liability with a rare combination of Financial Lines experience that includes serving as a chief underwriting officer, global head of product development and a foreign general insurance chief legal counsel for a leading insurance carrier.  Today, Rob counsels clients and serves as a thought leader and technical expert, trouble shooter, and claims resource on Financial Lines issues with a focus on D&O and Fiduciary products.  He co-leads the Willis Towers Watson Strategic Solutions Group and chairs its North American and Global FINEX Advisory committees.

The legend of Robin Hood has been around 700 years or so–an enduring, popular fairy tale of an outlaw hero and his band of Merry Men who robbed the rich and gave to the poor.  By comparison, Robinhood Markets, Inc., formed in 2013, looks to “provide everyone with access to the financial markets, not just the wealthy.” What makes Robinhood particularly interesting is its growth, how it is different and its impact, this year, on financial markets.

If growth and trading volume are the measures, Robinhood is succeeding.  Bloomberg reports that 1.7 million people opened brokerage accounts with Charles Schwab in the second quarter of 2020 — a 328% increase from the same period a year ago.  The Robinhood app added 3 million accounts in the first four months of 2020 and its payment order flow revenue doubled from Q1 to Q2. In June, Robinhood saw 4.3 million daily average revenue trades (DARTS)—higher than all of the major incumbent brokerage firms and more than E-Trade and Charles Schwab combined. In May, Robinhood raised $280 million in venture funding suggesting a then pre-money valuation of $8.3 billion.   Then, on August 17^th, Robinhood announced it had raised another $200 million suggesting a $11.2 billion valuation.  So, yes.  Successful.

Robinhood and its peers have made an impact.  The Wall Street Journal reported on August 24th that the S&P 500 hit a record close on the prior Friday—its first since February.  FactSet reported that price/earnings ratio on the S&P 500 @25.26—the highest since 2002—when the dot.com bubble burst and the Nasdaq Composite stock market index fell 78% from its peak. Meanwhile, unemployment is high and earnings remain under pressure from the COVID-19 pandemic.    One trend credited in part for fueling this market and upsetting long-standing norms in capital markets is the tsunami-sized wave of retail trading by newbie investors.  Many of them have begun investing with zero-fee trading apps such as Robinhood, Webull and Youinvest, but traditional brokers have seen massive growth, too.

But Robinhood seems different.

• Tracking: Until recently, Robinhood’s investors’ trading data—available by API-was compiled and reported by Robintrack.net.  Robintrack would report how many Robinhood users hold a particular stock over time. It generates charts showing the relationship between price and popularity, and compiles some lists using the data. This data had become an obsession for investors and analysts looking to gauge the impact of retail investors on market behavior.
• Fractional Shares: Also, Robinhood offers fractional shares.  So, users can trade stocks and ETFs in pieces of shares, in addition to trading in whole share increments.    Fractional shares on Robinhood can be as small as 1/1000000 of a share, and trading fractional shares is real-time and commission-free.  Want to by $25 of Tesla (trading at $2,170.02/share pre-market on August 24^th)? No problem.  Bloomberg reports [here] that, “[s]tarting in late April, traffic to the site exploded, jumping from about 4,000 to anywhere between 20,000 and 50,000 unique users per day.”  Robinhood’s users trade the riskiest products and at the fastest pace, according to research firm Alphacution for The New York Times.  In the first three months of 2020, Robinhood users traded nine times as many shares as E-Trade customers and 40 times as many shares as Charles Schwab customers, per dollar in the average customer account in the most recent quarter.
• Gamelike App: Trading on the Robinhood app is different, too.  In what has been described as from “easy to use” to “gamelike,” Robinhood’s app fills users’ screens with digital confetti and information on other stocks that its users are buying. A recent Wall Street Journal article [here] questioned whether the app made trading too easy—reporting that behavioral researchers say the app’s simplicity encourages novice investors to take bigger risks.  While Robinhood asserts it doesn’t make recommendations to buy and sell securities, the app does shows users related stocks that other Robinhood users also own.
• Incentives: Free stock??  Really?  It’s true. According to Robinhood’s website [here], “for every new friend you invite to join Robinhood, you can both earn a free stock! As soon as the conditions in your promotion are satisfied, we’ll credit both of your accounts with a free stock. You’re eligible to receive up to $500 in reward stocks each calendar year—so feel free to tell all your friends.”
• Day Trading: Others blame unlimited free trading rather than Robinhood’s app for encouraging day-trading—and Robinhood asserts, “[t]he vast majority of Robinhood customers are not day traders.”
• Payment Order Flow Revenue Model: Robinhood derives its revenues from a controversial practice known as “payment for order flow” in which companies pay to be the other side of a trade or to at least get the first right refusal.  This process could mean that a Robinhood order isn’t happening on a public exchange. Some say the process helps market efficiencies, but others question whether the user is getting the best price for their trade.

The Robinhood Effect:  Why are Robinhood’s users and other newbie investors being blamed for the irrational market behavior?  Some had argued that Robintrack.net and other information Robinhood provides its users drove a momentum play that could become a self-fulfilling prophecy.  Half of Robinhood’s 13 million users had never invested before signing up.  Do these newbie investors understand the financial risks?  Leon Cooperman, billionaire investor, doesn’t think so.  In a recent CNBC interview, he cautioned, “[t]hey are just doing stupid things, and in my opinion, this will end in tears.”    Where do those many of the newbie Robinhood users look for information?  From Tik Tok and other social platforms, naturally.  TikTok videos under #robinhoodstocks have more than 3.1 million views and #investing tag on TikTok has grown to 527.6 million views (both as of August 24th).  Cooperman may be right!

Will recent changes temper the Robinhood Effect?  Recently, Robinhood announced that it plans to curtail access to its API and certain data used by Robintrack.net that provided hourly updates on retail stock demand, and that became hot fad on Wall Street. The data from the app showed broad trends among Robinhood users’ trading to display which stocks were popular with its clients. Robinhood will stop providing the feed on which the site’s information asserting the move is based out of concern that that data was often “misconstrued” and “misunderstood.”  If these changes mean Robintrack.net is done (as seems to be the case), that may help Robinhood avoid some of the market attention it has received lately; however, it may not eliminate the momentum effect that some have attributed to Robinhood users and that may continue to be fueled by any information Robinhood continues to provide its users on the purchases of other users.

The Robinhood Effect, to me, is a D&O liability enigma.  How should we factor in the sometimes seemingly non-traditional behavior its impact on momentum investing? How should Robinhood users’ non-traditional information sources (like Tik Tok) impact how those users may factor into securities claims? I offer a few more specific questions that we may see answered sometime soon:

• Should we look at stocks with high Robinhood/retail investor trading as having greater exposure to heightened severity? From a D&O liability perspective, inflated markets can signal the potential for increases in D&O losses with a significant potential for higher than normal severity.  If Robinhood investors exacerbate that inflation, they may also increase potential D&O claim severity. Does that inflation warrant recalibrating upward how much D&O coverage is needed?
• How will, if at all, the seemingly different mix of information underlying trading by Robinhood users change how those users are factored into securities class actions?
• Can a user with 1/1000 of a share be included in a class of shareholders? I suspect yes, but wonder how this fractional share ownership could impact securities class action in the future.
• Can users who relied solely on the information Robinhood provides about its other users’ trading avail themselves of a presumption of Fraud-on-the-Market? Can defendants with significant Robinhood trading in their stocks rebut any such presumption if it does apply?  Would doing so be worth the effort?
• Could the Robinhood Effect impact how class damages are calculated? Would documented Robinhood Effect inflation serve to support defense efforts to reduce and undermine plaintiff’s-style damages or the impact of inflationary disclosures?

Worth us keeping an eye on this Robinhood Effect.  No fee trading is likely here to stay.  Fractional trading is too.  While the investor information mix provided by any trading app can change with each revision, we may be revisiting Fraud-on-the-Market again sometimes soon.  Some of this phenomenon, at least, is more than a short-term fad.