Robinhood’s Reckoning: Can it survive the GameStop bubble?

Mr. Tenev and his co-founder, Baiju Bhatt, had set out eight years earlier to bring the stock market to a new class of investors. With engineers plucked from Facebook Inc. and other tech giants, they stripped down the trading experience and eliminated commissions, making buying a share of stock about as easy as posting a photo on Instagram.

It worked. During the pandemic, throngs of amateur investors—homebound, bored and flush with stimulus checks—opened Robinhood accounts to experience the market’s thrills. By the end of December, the firm had amassed about 20 million users, according to people close to it, and weeks later its app hit the top of download charts.

It should have been a moment to celebrate. Instead, Thursday of last week began with a panicked, predawn phone call informing Mr. Tenev that Robinhood needed to come up with billions of dollars if it wanted to open for business in a few hours.

His day ended on prime-time television, with a CNN anchor asking Mr. Tenev if Robinhood was trying to “starve the little guy." Robinhood’s breakout moment turned out to be the thing that nearly broke it.

The firm that set out to bring investing to the masses had run into the reality of Wall Street, with its tangle of often-expensive regulations, overseers and Byzantine infrastructure. A tech company at heart, Robinhood at times failed to give priority to things like customer service, communications and risk management—staid but essential tasks in the world of finance. It differed from most major brokerage firms in a critical way: It wasn’t part of a well-funded financial colossus that had myriad sources of cash and sprawling compliance teams.

Matters came to a head early on Jan. 28 when the clearinghouse that handles Robinhood’s trades demanded it put up a total of $3 billion to cover the day’s trading, a cushion for the risks created by a stunning run-up in a few stocks, such as GameStop Corp., fed by cheerleading on Reddit’s WallStreetBets forum.

The demand, 10 times Robinhood’s daily requirements earlier that week, set in motion a chain of events that included stopping customers from buying the very stocks that made the app so popular.

Many were furious. For hours—an eternity in markets—as Robinhood executives fretted about how to explain the situation, rumors filled the void. On WallStreetBets, posters floated the theory that Robinhood was shielding hedge funds that were in a bind because they had bet on these stocks to fall. A crowd of angry customers showed up at the firm’s Menlo Park, Calif., offices. Dozens filed lawsuits, and “#DeleteRobinhood" trended on social media.

Yet all the while, big investors were clamoring to get a piece of Robinhood and its explosive growth. The firm’s executives, looking to amass capital in little time, dialed up a long list of existing backers and potential new ones. The deal it reached with some of them was a note convertible into equity at a discount to a future initial public offering price.

It ultimately cut this off at $3.4 billion raised. Only Juul Labs Inc., Uber Technologies Inc. and WeWork have raised more in a single venture-capital round since 2002, according to data provider PitchBook.

The next few months will test Robinhood like no other time since its founding. Mr. Tenev and his team told investors they still plan to take the company public sometime in the first half of the year, according to people familiar with the matter. To do so, he will have to clear the high growth bar set by Wall Street investors while simultaneously repairing Robinhood’s ties with the novice traders who made it go viral.

“We haven’t really been in a situation where we see the intersection of financial services and social media," Mr. Tenev said in an interview last week. “It’s become a cultural phenomenon."

He and Mr. Bhatt were Stanford University classmates who got the idea to start Robinhood a decade ago. They were developing software for ultrafast trading firms when the Occupy Wall Street protests inspired them to make a smartphone app that would expand access to financial services beyond the well-heeled.

Robinhood didn’t look like a typical bank or brokerage. Executives touted the share of its workforce made up of engineers, designers and product managers. In 2018, it moved its headquarters into the former campus of the West Coast lifestyle magazine Sunset in Menlo Park, a ranch-style complex with a wood-and-stone central courtyard where workers could eat the breakfasts, lunches and dinners Robinhood provided as a perk.

Mr. Tenev was known internally as “the head" for his focus on numbers and growth, while Mr. Bhatt was called “the heart" for his interest in design and the look and feel of Robinhood’s app, said people close to the firm.

Many of the rank-and-file at Robinhood were unfamiliar with the regulations of finance. Banks and their examiners monitor electronic chats among traders and deal makers to ensure compliance with industry codes of conduct. At Robinhood, some employees were surprised that their communications on Slack, where they discussed work, were accessible to regulators, said people close to the company.

At one point, the Financial Industry Regulatory Authority, Wall Street’s self-regulatory arm, chided employees for joking on Slack about an issue they were working on late into the night, one person said.

A Finra spokeswoman declined to comment. In December 2019, Robinhood agreed to pay Finra $1.25 million to settle claims that it hadn’t made sure customers’ trades were executed at the best prices between late 2016 and late 2017. The company didn’t admit or deny fault but agreed to hire an independent consultant to review compliance practices.

Silicon Valley principles of user engagement and word-of-mouth marketing animated Robinhood’s thinking. It borrowed visual cues from gaming apps, such as confetti that appeared on-screen to celebrate new trades or deposits. One feature asked users to virtually scratch off a mystery card to win a free share of stock.

Gimmicks like wait lists and giving users a free share if they bought a stock for someone else worked to bring in new users and meant less need for traditional advertising.

Robinhood set itself apart by how easy it made trading. Users could buy up to $1,000 worth of stock with a few smartphone swipes after they opened an account—even before their bank transfer to fund the account had cleared. Those who paid $5 a month to join the firm’s premium program could buy $5,000 or more of stock instantly and borrow to buy stocks at an annual rate of 2.5%, very low for what are known as margin loans.

Despite Robinhood’s populist ethos, much of its revenue came directly from Wall Street. Robinhood earned extra income by lending shares of Tesla Inc. and other popular stocks to short sellers, who hope to make money by seeing the stock fall.

And like other retail brokerage firms, Robinhood routed customers’ orders to high-speed traders, which paid for the right to execute many of the trades. That business, known as “payment for order flow," earned Robinhood $687 million in 2020, according to securities filings. In December, Robinhood agreed to pay a $65 million settlement to the Securities and Exchange Commission for misleading customers for years about its reliance on those deals. (Robinhood didn’t admit wrongdoing.)

By March 2020, Robinhood was one of the most valuable startups in Silicon Valley and among the few that could credibly claim to have changed an industry. Months earlier, Charles Schwab Corp., E*Trade Financial Corp. and other big firms had said they were following Robinhood’s lead and taking commissions down to zero.

But Robinhood wasn’t prepared for an onslaught of orders when the pandemic sent stocks plunging. Users who had opened accounts but never funded them or traded showed up en masse to buy and sell, at levels that far exceeded Robinhood’s historical averages and projections, according to a person familiar with the situation. Its systems groaned under the volume, and on March 2 it went offline for most of the day.

While engineers scrambled to fix the problems, Robinhood communicated little to the outside world about what was happening. When Messrs. Bhatt and Tenev published an explanatory blog post the following day, after another morning outage, the explanation was wonky. Robinhood blamed a “thundering herd" effect that triggered a failure of its “DNS system."

Around that time, Robinhood drew down hundreds of millions from credit lines to meet requirements, imposed by the entity that helps it finalize trades, for collateral against the higher volume and volatility, said people familiar with the situation. It was a preview of January’s chaos.

Executives had put together a road map for 2020, including product launches and an expansion to the U.K., but had to abandon it just to keep up with the user growth at its main brokerage business, according to people familiar with their plans.

Though employees had been told the firm’s goal was to provide “insane customer service," Robinhood had only about 100 people assigned to respond to users’ issues last spring, according to people familiar with the matter. The firm didn’t operate a hotline users could call to seek help. Agents responded only to emails and social-media messages.

Limitations in customer service continued into the summer, when a 20-year-old student named Alex Kearns tried to reach a Robinhood customer-service representative in the middle of the night regarding a sophisticated options position. An amateur trader, Mr. Kearns was rattled when he thought his account statement showed he had lost three-quarters of a million dollars.

Mr. Kearns received an automated email reply from the company, according to people familiar with the matter. He killed himself on June 14, leaving a note that asked how someone of his inexperience was allowed to trade so easily. Mr. Kearns’s father declined to comment.

At the time, a relative told The Wall Street Journal that Mr. Kearns appeared to be looking at a figure on his account statement representing one leg of a trade that was losing money, but not the opposing leg that was gaining value.

After reports of the suicide circulated, Mr. Tenev addressed employees at a weekly all-hands meeting, pledging to do better, according to people who listened to the meeting. It took Robinhood until June 19 to publish a letter from Messrs. Tenev and Bhatt announcing a review of its options trading eligibility rules and user interface, along with a $250,000 donation to the American Foundation for Suicide Prevention.

Robinhood hired hundreds more customer-service agents, bringing its total to more than 1,000 at the end of 2020, people familiar with the firm said. While it still doesn’t operate a hotline, Robinhood recently added a feature that allows some customers to request a phone call from a real person, which wasn’t an option previously, the people said.

Heading into 2021, Robinhood had reason to believe it had fixed many of its problems. It had named a former SEC commissioner, Dan Gallagher, its chief legal officer in May, giving management more financial and compliance knowhow. In August, it hired Christina Smedley, a PayPal Holdings Inc. veteran who formerly handled marketing for Facebook’s cryptocurrency project, to run Robinhood’s marketing and communications teams.

The company had set out to raise an abundance of capital after its scare in March 2020. It expanded bank credit lines. Investment rounds announced in May and August gave it a total of $1.26 billion in fresh equity, more than it had collectively raised previously.

The last investment round valued the company at nearly $12 billion and led executives to believe their balance sheet was sufficiently fortified. They weren’t prepared for the jet fuel that Reddit’s message boards were to pour on retail trading—and Robinhood’s growth.

In the last week of January, hundreds of thousands of traders were opening Robinhood accounts daily to buy GameStop and a few other stocks.

The simplicity of the firm’s user interface masked the complexity of the different parties that touch each trade. Those include clearinghouses that collect and distribute payments for customers’ orders and officially transfer ownership of stocks.

Clearinghouses can take days to finalize a transaction. To account for the risk that a trade—or a brokerage firm—could fail before the process is complete, clearinghouses require brokerage firms to post collateral each day to guard against potential losses.

Collateral requirements can be unpredictable. The formulas clearinghouses use to arrive at their requests aren’t available to the public. But the amounts are known to go up in volatile times and when a broker’s customers concentrate trading in a small number of stocks.

On Thursday, Jan. 28, before dawn broke on the West Coast, Mr. Tenev and his team frantically strategized how they could lower the day’s $3 billion bill from their clearinghouse. They concluded that if they restricted trading in the most popular stocks, that should be enough to convince the clearinghouse risk was being reduced.

Users would be allowed to sell certain hot stocks. But if they tried to buy, they would see an error message, through code Robinhood’s developers would have to write on the fly, according to a person familiar with Robinhood’s thinking.

Depository Trust & Clearing Corp., which operates the main clearinghouse for U.S. stock trades, agreed. The capital request was reduced to about $1.4 billion. Robinhood already had roughly $700 million on deposit there, meaning it only had to post an additional $700 million.

The firm could afford the lowered tab, especially after it borrowed about $500 million from its bank credit lines. But executives worried that the frenzied trading would combine with its surging growth to bring more big clearinghouse demands. Mr. Tenev worked the phones seeking an emergency infusion that would see Robinhood through the trading boom.

Within hours, it had commitments for more than $1 billion, with much of it wired into Robinhood’s bank account before the end of the day.

The deal took the form of a convertible note that entitled its holders to invest in Robinhood’s eventual IPO at a 30% discount or at a valuation of $30 billion, whichever figure was lower, according to a person familiar with the matter. Some investors who came into the round late did so on terms that were slightly more favorable to the company, this person said.

After Robinhood announced the $1 billion financing on Friday, Jan. 29, executives were surprised at the volume of interest they got from venture capitalists, hedge-fund managers and high-net-worth individuals looking to get a piece of the fast-growing company, according to people familiar with the matter.

Tiger Global Management invested $250 million in Robinhood over the weekend, a person familiar with the matter said. Iconiq Capital LLC, an investment firm whose clients includes wealthy individuals such as Mark Zuckerberg, participated in the round and tapped its network of family offices and institutions to see if any wanted in, people familiar with the move said. Investors in venture-capital funds that owned Robinhood shares clamored to be included, some of the people said.

On Monday, Robinhood said it had raised an additional $2.4 billion. Venture-capital firms Ribbit Capital, Sequoia Capital, Index Ventures and Andreessen Horowitz were among the big participants. Believing it had more than enough capital, Robinhood loosened the restrictions on buying shares in hot stocks.

Unlike in March 2020, Robinhood didn’t suffer any stock-trading outages during the January frenzy.

One of the firm’s challenges now will be keeping its users happy. In a live stream on Sunday over Clubhouse, an invitation-only social networking app popular in Silicon Valley, Tesla CEO Elon Musk asked Mr. Tenev if he had “sold your clients down the river." Mr. Tenev, whom Mr. Musk called “Vlad the Stock Impaler," said Robinhood, like other financial firms, needed to comply with regulations.

The company sent customers an email about its decision to restrict stock buying. “We hope you take away this: at Robinhood, we stand with everyday investors participating in the markets," it read. A Robinhood commercial with the slogan “We are all investors" is expected to air during the Super Bowl on Sunday.

Brad Williams, a 42-year-old investor in Birmingham, Ala., is unconvinced.

Mr. Williams said he opened a Robinhood account about two years ago after he saw the firm marketing a free share of stock for joining. Also a member of the WallStreetBets forum, he joined the sudden rush to buy GameStop in January.

Even though he made money on the trade, Mr. Williams said he is planning to close his Robinhood account. “Before last week, I would have said I enjoyed Robinhood and had no issues," Mr. Williams said. “This week is a different story."

Mr. Tenev is expected to appear on Feb. 18 before a House Financial Services Committee hearing titled “Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide."

Rep. Brad Sherman, a California Democrat who heads the House Financial Services’ subcommittee on investor protection, said Robinhood should have better communicated with customers about its sudden trading restrictions.

“I don’t think they are in a position to say they are trying to protect their customers," he said. “That’s like walking into a casino and expecting them to come over to the table and say, ‘Hey, Brad, haven’t you lost enough?’"

This story has been published from a wire agency feed without modifications to the text.