On January 12, GameStop Corp. (ticker symbol: GME) closed at a price of $19.95/share on a volume of approximately 7 million trades. Only 15 days later, GME closed at a price of $347.51 on a volume of 93.45 million trades. Investors who bought on January 12 and sold on January 27 enjoyed almost 1,800% in appreciation. In 15 days. The reason behind the meteoric increase has now become very well documented. A Reddit community forum named “Wall Street Bets” (r/WallStreetBets) used the power of its more than 2.9 million subscribers to wage war on Wall Street hedge fund short sellers. First off, what just happened? Was it legal? And what lessons does it hold for companies that are later swept up in a similar frenzy?
The Basics: Short Sale, Short Squeeze, and Reddit’s Influence
A short sale of an equity occurs when an investor (short seller) borrows a number of shares of a stock for a fee and/or at an interest rate – and often on margin (on loan) – from another investor who already owns shares of stock in the company. The short seller sells the stock at the current price with the expectation that the price of the stock will fall, and the short seller will ultimately be able to purchase the stock at a lower price. When the short seller purchases the stock at the lower price, they can return the stock to the initial owner, locking in the proceeds for themselves. Short selling can be a very high-risk arbitrage; theoretically, the price of the security can rise to infinity and the short seller will not only be forced to purchase the stock at the higher price but will have to pay the owner of the stock interest. Buying a stock with the intention of short selling is described as having a “short position.”
In the case of GameStop, predominantly individual (or non-institutional) investors who subscribed to the Reddit community r/WallStreetBets recognized that hedge funds had taken an extremely aggressive short position on GameStop and several other stocks. As much as 140% of the outstanding shares of GME had been shorted. The company is a brick and mortar seller of videogames in a time when many videogame players have pivoted to streaming video games. Short sellers likened GameStop to Blockbuster Video just prior to the advent of Netflix’s streaming service.
In an effort to take advantage of Wall Street short sellers, the r/WallStreetBets community engaged in an effort to drive up the price of the stock. Subscribers of the group encouraged each other to purchase as many shares of GME as possible to artificially inflate the price of GameStop stock and saddle the short sellers with enormous losses. Short sellers soon found themselves caught in what is known among Wall Street investors as a “short squeeze.”
A short squeeze is a term used to describe a feedback loop that continuously drives up the prices of the stock. As discussed earlier, the short sellers are forced to purchase the stock, despite the rising prices, in order to cover their position and minimize the losses resulting from their bet that the stock price would fall. But, large orders to purchase stock drives the prices up even more, resulting in a continuous loop of rising stock prices. Using this strategy, as of January 28, the community of r/WallStreetBets had driven up the price of GME, resulting in a loss of $1.6 billion for short sellers – and significant unrealized gains for holders of GameStop stock. For example, as of January 29, 2021, an individual who uses the pseudonym “Roaring Kitty” in the r/WallStreetBets Reddit community bragged that they had turned a $53,566.04 investment in GameStop stock into $48 million.
Investors in GameStop are not the only ones benefiting from r/WallStreetBets’ attack on Wall Street short sellers who targeted companies that have struggled in the pandemic. During the week of January 25, the per share price of several other companies witnessed dramatic volatility as a result of the group’s efforts. AMC Entertainment Holdings (AMC) saw its stock rise from less than $5.00 a share to $20.30 in one day, a 300% increase. Dogecoin, a cryptocurrency started as a joke in 2013, saw gains of more than 800%. Blockbuster, despite having only one remaining store open in 2019, saw its stock price rise 700%. BlackBerry, Nokia Oyj, and Tootsie Roll all saw significant increases in their stock price.
How did r/WallStreetBets leverage the influence of social media – and specifically Reddit – to “punish” the large Wall Street hedge funds by driving up the share prices of stressed companies? Reddit describes itself as “a social news aggregation, web content rating, and discussion website.” Members of the website subscribe to threads and submit content to the site. User posts are anonymous. The content is then “upvoted” or “downvoted” by other members. User posts are organized into “communities” or “subreddits” based on their content. An algorithm determines which posts are placed at the top of page based on “upvotes,” comments, and time elapsed since the post was made. Reddit currently has an average of 52 million daily active users and has accrued more than 430 million monthly active users by the end of 2019. And the number keeps growing every single day. The size of this grassroots community allowed the r/WallStreetBets access to investors who could influence the direction of the share price of companies they identified as “vulnerable” – those with significant short positions.
Was It Legal?
Many, many people – especially those who did not benefit from the run up in share prices – are questioning the legality of r/WallStreetBets’ use of its influence to manipulate companies’ share prices in spite of the weak fundamentals of the companies. At the forefront of the inquiry are the U.S. Congress and the U.S. Securities and Exchange Commission (SEC), but the U.S. Department of Justice (DOJ) is likely not far behind. There are a few possible ways in which the r/WallStreetBets community may have violated state and/or federal statutes.
Pump and Dump
A source no less than Jordan Belfort, the real life Wall Street investor played by Leonardo DiCaprio in the Hollywood film “The Wolf of Wall Street,” has identified the r/WallStreetBets’ actions as a modified “pump and dump” or an illegal scheme designed to boost a stock’s price using false and misleading statements about the company. For example, an investor purchases Company X’s stock. The investor then spreads false rumors that Company X has engaged in an exclusive deal with Company Y that is sure to increase Company X’s value. However, the investor has no such information. The investor’s hope is that this news will fraudulently influence other investors into buying Company X’s stock because they believe the company’s value is going to increase. If the false rumors are believed and other investors buy Company X’s stock, the stock price increases. The rumor-spreading investor then sells its Company X stock before the falsity of the information is made public and takes the proceeds before the subsequent drop in share price. Since the “deal” was a sham, the value of the company does not actually increase, and the stock price soon falls back down once the rumors dissipate, leaving all of those individuals who bought stock based on the false rumors with large losses. These schemes have become prevalent on social media sites and elsewhere on the internet; often the promoters of the false rumors claim they have inside information or a tip and urge people to buy the stock quickly.
The key difference between a classic pump and dump and the r/WallStreetBets community’s actions is that there does not appear to have been any false or misleading information spread in an attempt to boost stock prices. The r/WallStreetBets thread is filled with individuals desiring to buy stock not because they had some inside information that GameStop or the other companies were going to make a big comeback, but because they wanted to force the position of hedge fund short sellers. While no one can say money was not a factor in their decision, the r/WallStreetBets posters assert that self-profit was not their primary motivation.
Yet, despite facing potential enormous losses as a result of significant dips in stock values, many of the users in r/WallStreetBets claim to be holding out and demanding other users “hold the line,” all in the name of “punishing” hedge fund short sellers. One user, “keyboredwarrior,” summed up the attitude of many on the thread by saying, “We just need to hold and bleed them to death…. We got nothing to lose for holding the stock, they have billions to lose.” This type of transparency may cause challenges for regulators, legislators and Department of Justice officials seeking to punish or prevent this type of activity in the future.
Another possible characterization of the r/WallStreetBets users’ action is market manipulation. Federal statute 15 U.S.C. § 78i exposes violators to an enforcement action if they are found to have manipulated the price of securities. Market manipulation occurs when an individual artificially affects the supply or demand of a stock, causing the price of the stock to rise or fall dramatically. In order to prevail in a market manipulation case, the SEC has to prove a four part test: “(1) that the accused had the ability to influence market prices; (2) that the accused specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand; (3) that artificial prices existed; and (4) that the accused caused the artificial prices.” It is safe to assume that the SEC does not have the resources to go after everyone who bought GameStop stock as a result of this movement. r/WallStreetBets’ subreddit subscriptions have increased from 1.7 million at the beginning of January to 6 million as of January 29. The SEC’s limited resources would make it challenging to track down all of these “anonymous” users and levy penalties against them. However, the SEC may elect to identify the individuals that started it all and target them for a market manipulation enforcement action.
Market Manipulation by Retail Investors?
This is somewhat an issue of first impression that will significantly test the limits of what constitutes market manipulation. In the past, the SEC has investigated individuals who have colluded to inflate or deflate stock prices. For example, in 2015 the SEC investigated a group of activist investors who coordinated their efforts to buy and sell stock. The key issue during that investigation was that the group failed to file a schedule 13D with the SEC. A schedule 13D is an SEC filing that must be submitted to the SEC when a person or group acquires more than 5% of any class of publicly traded securities.
A situation even more similar to the recent GameStop phenomenon occurred in 2014, when the SEC investigated improper collusion among hedge fund investors. The investors were accused of improperly colluding, again without filing a schedule 13D with the SEC. In that case, the investors sought to work together and short squeeze billionaire investor William “Bill” Ackerman, an analogous motive of r/WallStreetBets, albeit on a much smaller scale. However, the SEC will face a challenge in proving that the individuals on the subreddit were actually colluding with one another and that they owned more than 5% of publicly traded securities. For instance, it would be a factual determination as to whether it is illegal for an investor to publicly state they are purchasing GameStop stock and encouraging others to do the same. The scale of the r/WallStreetBets pronouncements – almost 6 million subscribers on a Reddit thread – may allow the SEC to pursue them for market manipulation, especially since the r/WallStreetBets community appears to have done so for the sole purpose of inflating the stock price to short squeeze hedge fund investors.
But the r/WallStreetBets scenario presents unique challenges that may not align with past SEC investigations. For one, r/WallStreetBets and its subscribers appear to have been completely transparent, even forthcoming, as they advertised their actions over the social media platform. To complicate matters even more, the actions of r/WallStreetBets were not only being observed by its 6 million anonymous subscribers, but by the rest of the world. Anyone keeping up with the news and deciding they want to take part in facilitating a short squeeze is allowed to passively read the thread to discern what the masses are doing. The transparency of it all could prove to be a double-edged sword though. Traditionally, collusion among investors is difficult for regulators to prove because it’s often done in secrecy, but the open encouragement among users would make it easier in this case.
Of course, if there were individuals on the thread spreading false information or misleading individuals, they could not only be charged under 15 U.S.C. § 78i but under the Securities Fraud statute, 18 USC § 1348, as well. This statute makes it a crime to defraud or mislead another person in relation to the sale or purchase of a commodity. However, to date, there have not been any indications that fraudulent or misleading statements have been made in an effort to induce people following the thread to buy stock.
Market Manipulation by Robinhood and Other Investment Companies?
The r/WallStreetBets subscribers might not be the only ones facing regulatory scrutiny. The topic of market manipulation has also arisen in response to the move by Robinhood and other investment apps to suspend the ability to buy those stocks involved. Founded in 2013, Robinhood is an app that offers commission-free trading of stocks and exchange-traded funds (ETFs). Robinhood prides itself on setting out to “democratize finance for all" and says, “We believe that everyone should have access to the financial markets.”
In a fight some view as an attempt to democratize a stock market becoming increasingly untethered from reality, Robinhood faced enormous backlash for its action following the surge in trading volume and stock prices. On January 28, the management team of Robinhood made the decision to allow users to only sell – not purchase – the stock of specifically identified companies including GameStop, AMC, and others targeted by r/WallStreetBets. The company cited “market volatility” as the reason behind the move. Robinhood continued a limited version of this prohibition on January 29, allowing users to only purchase one share of each company per day. However, hedge fund investors could still buy and sell the stock at unrestricted volumes on other platforms. In addition to the tremendously negative press this brought a company (ironically) named Robinhood, the move was decried by many as market manipulation in and of itself.
The outrage even managed to bring together the most unlikely allies, as Rep. Alexandria Ocasio-Cortez, Sen. Ted Cruz, Rep. Rashida Tlaib, and Donald Trump Jr. all tweeted in agreement that Robinhood’s actions were wrong and needed to be investigated further. Rep. Ocasio-Cortez tweeted, “This is unacceptable. We now need to know more about @RobinhoodApp’s decision to block retail investors from purchasing stock while hedge funds are freely able to trade the stock as they see fit.” Sen. Cruz tweeted in response, “Fully agree.”
In a rare move, the SEC put out a joint statement addressing the recent frenzy and promising to “closely review actions taken by regulated entities that may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities.” The statement went on to say that the SEC “will act to protect retail investors when the facts demonstrate abusive or manipulative trading activity that is prohibited by the federal securities laws,” promising to “identify and pursue potential wrongdoing.” The statement signals that the SEC is monitoring moves by entities like Robinhood as well as conduct by r/WallStreetBets retail investors.
Future Considerations for Companies Caught in the Middle
As non-institutional investors increasingly flex their muscles, it is possible other stocks will be targeted by social media platforms in the future. While this approach may, in fact, be democratizing, it can also have a devastating impact on the market as a whole and on individual companies. Furthermore, volatility and inexperience will cause a vast majority of the retail investors that participate in this kind of scheme to suffer debilitating losses. Actions like those taken by Robinhood and other investment companies will invite litigation.
In fact, the same day Robinhood decided to halt trading, a class action was filed against the company by a retail investor on behalf of himself and “All Robinhood customers within the United States who were not able to execute trades on GME after Robinhood knowingly, willfully, and purposefully removed it completely from their platform.” This lawsuit is no doubt just the beginning of Robinhood’s legal issues as a result of the decision. The SEC and DOJ will have to weigh the perspectives of many different stakeholders in deciding how to move forward. The U.S. House Committee on Financial Services has scheduled hearings on this issue for February 18, 2021. Additionally, the Financial Industry Regulatory Authority (FINRA) is increasing regulatory oversight of app-based trading platforms like Robinhood, which feature "interactive" or "game-like" characteristics.
It is certainly possible – even likely given the publicity – that new market rules will be adopted. One possibility is the adoption of a limitation that allows for a finite percentage increase in stock price under these circumstances. These types of regulations would essentially act as a circuit breaker and ensure everyone is subject to the same rules, rather than leaving investment companies vulnerable and risking those companies making decisions that severely affect market conditions and lead to legal consequences.
Investment companies would not be the only companies caught in a sticky legal position during scenario’s like the r/WallStreetBets phenomenon. Companies targeted by the social media platforms, through no fault of their own, will also find themselves in a challenging position. The notion that a company would raise capital during such a run – as AMC explored – could be a recipe for disaster, and shareholder lawsuits would likely follow. The most prominent reason is how difficult it would be for the company to adequately disclose all of the risk factors associated with raising capital during one of these runs because of the disconnect between the company’s fundamentals and its price per share or its market cap.
What federal regulators do next will be critical for public companies, investment companies, and investors large and small to follow. There may also be action at the state level to address this kind of frenzy, such as by state attorneys general or lawmakers. The GameStop frenzy will almost certainly pave new regulatory ground and have implications for years to come.