How the Robinhood IPO is Different

Jonathan Macey is Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law at Yale Law School and Professor in the Yale School of Management.

Robinhood is a wildly popular discount broker/dealer whose specialty is providing easy entry into the addictive world of day trading for the newcomers it creatively recruits into the exciting world of equity trading. When Robinhood goes public, these new inductees to U.S. capital markets are about to find out how much the playing field is tilted against Main Street investors.

Unlike other initial public offerings, Robinhood is considering giving its own customers first dibs on the newly issued shares. These investors likely are going to learn the important lesson that if a deal seems too good to be true, then it probably is.

The usual first step in a public offering is to pre-market the new securities to folks who are either connected with the issuer or have good contacts with the investment banks in charge of underwriting the new shares, or both. But sophisticated investors are acutely aware of two structural features of the capital markets that ordinary investors fail to consider at their peril. First, insiders in control of companies selling their shares have much better information about what is going on in their companies than anybody else.

Second, while the insiders in companies selling their shares to the public cannot control the price of their IPOs, they have broad control over the other crucial variable in a stock sale: the timing of that sale. Selling shares is optimal for the issuer when the actual value of the shares being sold is equal to or less than the price that the shares can command in the market. Rational insiders always would prefer to wait until the price they can command for their companies’ newly issued shares is higher than the price that the market places on those shares at a particular moment in time.

Sophisticated investors are onto this game, however. That is why IPOs generally are sold at a discount to market. Sophisticated investors would never invest if they were offered at full price. Thus, initial Public Offerings have always been a sweet deal for rich and well-connected investors and a sucker’s game for the rest of us. For the rich and well-connected, IPOs provide a vastly profitable opportunity to pick up shares at a discount and sell them in the frothy IPO aftermarket.

Usually, the only shares available for the ordinary investor represent investments in companies that Wall Street insiders have decline to buy. Ordinary investors, who make the improvident decision to invest in IPO shares after the Wall Street big boys have passed, quickly find out what it means to be left with the dregs of the IPO universe. And what it means often is disaster, as share prices tank and the losses mount up when the markets discover the bad news that the Wall Street insiders knew all along about the issuing company that caused them to pass on buying these shares in the first place.

Facebook’s May, 2012 IPO is a stellar example of how IPOs work. I knew that the IPO was going to tank before it happened. While my skills as a stock picker are non-existent, I knew Facebook was going to tank because brokers were reaching out to me and telling me that I could buy shares in an IPO. This told me that the real Wall Street wise guys already had turned down the “opportunity” to invest. And sure enough, by summer, Facebook was trading at 44% below its IPO price. IPOs are definitely a club that ordinary investors should not join if invited.

In its short life, Robinhood has seen more than its share of scandals. Robinhood customer Alex Kearns committed suicide when he received the report from Robinhood that there was a negative cash balance of $730,000 in his account. His suicide actually called out Robinhood for its poor treatment of customers. Late last year Robinhood paid $65 million to settle the SEC’s concern that the Company’s customers were getting bad trade execution because Robinhood was selling its customer’s orders to high-frequency trading firms like Virtu and Citadel. The Massachusetts Securities Division has sued Robinhood for breaking the state’s laws by failing meet its legal duties to its clients. According to the state regulators, Robinhood’s trading platform, which looks like a video game, put novice traders who did not understand the risks associated with day trading, at acute financial risk.

Then there was the famous GameStop saga in which Reddit users piled into GameStop only to find that, when they wanted to trade their positions, Robinhood would not allow them to do so. Investigations from regulators are ongoing as are close to 50 class action lawsuits.

I still feel a sense of relief at my decision to take a pass on the Facebook offering. I urge Robinhood customers to think long and hard before diving into the Robinhood IPO.

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