An unprecedented new trading paradigm has emerged from a titanic showdown over the recent surge in valuation of several “nostalgia” stocks, ultimately leading several brokerage firms, such as Robinhood Markets, Inc., to place outright restrictions on stock purchases. The following article provides core legal and regulatory observations about the chaotic market dynamic that exploded last week amid social media fueled trading that saw names like GameStop,1 and to a lesser degree AMC, skyrocket to the proverbial moon.2
Last week's events originated from the efforts of a group of investors who were active in the “WallStreetBets” (WSB) sub-community of popular internet website Reddit, which bills itself as the “Face of the Internet.” Collectively, WSB has over eight million members. Recently, those WSB members – “Redditors,” as they are colloquially known – realized that Wall Street hedge funds, such as Melvin Capital, had taken enormous short positions in GameStop and AMC. In the most glaring example involving GameStop, the hedge funds had collectively shorted more than 100% of the available tradeable shares. This short selling, essentially betting on GameStop shares going down to $0, generated disdain among the WSB community and resulted in the Redditors publicly banding together to aggressively encourage members to drive up the stock by buying shares.
This revolt was aided by the recent introduction of commission-free trading by several brokerage firms, most notably Robinhood. This buying pressure sent the stock price skyrocketing, ultimately causing many of those negative funds to cut their losses (which were enormous in some instances) by purchasing shares to “cover” and close their positions – which itself added to the buying pressure and increased the stock price. This “short squeeze” sent GameStop's price up from a January 4 price of $19.00 to a closing price of $328.24 on Thursday, January 29 – an over 600% increase. This “herd mentality” was evident in the trading activity of GameStop and AMC, which quickly pared most of their gains by earlier this week while other purported targets of the Redditors such as silver and biotech stocks surged.
The escalating and, at times, almost theatrical “war” of sorts between “the shorters” and “the squeezers” cannot be overstated in terms of the breadth and diversity of its impact. The consequences are still playing out in real time and so far include (without limitation):
- Short sellers losing billions.3
- The strategies and disclosures relating to short selling positions rising to the fore.4
- Private, class action lawsuits around the country being filed against brokerage firms, such as Robinhood5, for imposing trading restrictions on certain stocks, arguably causing those stocks to temporarily drop.6
- Congress, including normally political “enemies,” calling for hearings into Robinhood and other players as well as the circumstances triggering the volatility.7
- Statements from the SEC and state attorneys general indicating they are monitoring and investigating “abusive” and “market manipulation” activity.8
- Questions regarding whether the activity of the retail, online purchasers of these stocks may have been engaged in illegal “ market manipulation.
- Where it all ends, when as most experts suggest, the price of these stocks eventually plummets (when the “bubble” created by the artificial run up on prices “bursts”).
As this situation has progressed, there are signs it may prove to be a transformative, rather than a transient, movement.
Core Takeaways from the Emerging Legal, Regulatory and Market Questions
Some important legal, regulatory and market questions arise out of this drama. We ask and answer a number of what we see as important questions, offering some core takeaways.
One of the core questions is whether or not firms like Robinhood will face consequences from its imposition of trading restrictions during the height of the frenzy. Although not a straightforward answer, this seems unlikely (except perhaps in the court of public opinion). First, it will be difficult to prove or establish any sort of “conspiracy” between Robinhood and any institutional investor that led to the decision. Second, even if it is assumed that the decision to restrict trading triggered a temporary, albeit massive sell off, and accompanying massive drop off in stock price, there were arguably sound, and more importantly, legally defensible regulatory and best practices explanations for why the trading restrictions were initiated. Third, Robinhood's customer agreement provides it sole and wide discretion, including to “prohibit or restrict the trading of securities.” Finally, we anticipate that the legal fervor will die down given that most, if not all, of the proceedings are subject to the mandatory FINRA arbitration provision contained within the Robinhood customer agreement.
Ultimately, Robinhood (and other similarly-situated brokerage firms) took action knowing that lawsuits would likely follow. Despite the overtures to their “populist” base about free trading, what happened is a stark reminder that Robinhood has become a large market presence subject to the same regulatory and legal framework as its fellow market participants.
SEC, FINRA and Attorneys General
On a macro level, we expect and predict there will be a significant percentage uptick in regulatory enforcement activity as a general matter under a new, Democratic majority in the legislature and executive branch. That said, do we expect to see any sort of regulatory explosion of SEC or enforcement proceedings arising out of last week's market frenzy, or any future one between shorts and retail investors squeezing back? The answer is no. We predict it highly unlikely there will be too much in the form of actual enforcement activity against traders, such as the WSB day traders. First and foremost, it is not legally or economically practical. Second, there will be significant regulatory and enforcement challenges to proving that there is illegal market manipulation here. Can social media and investors “artificially” influence or drive stock prices? The answer seems clearly, yes. But what is far less clear is whether said conduct is somehow illegal as a regulatory or criminal matter. Having a purported motive to “do battle” with short sellers, or to try and create access and opportunities to trade, where millions can be made or lost on stocks may simply prove to be legitimate, lawful conduct. While enforcement proceedings could theoretically elasticize certain concepts of market regulation (e.g., the definition of who is an investment manager for reporting requirements under Section 13 of the Securities Exchange Act), it will not be easy to prove any sort of wrongful conduct by the day trading community, as a whole.
On Monday, FINRA stated in its annual priorities industry report that it will be increasing its oversight of app-based, “game-like” trading platforms on issues relating to disclosure, fees, and compliance with SEC regulations. In this report, FINRA cited a surge in new investors entering the marketplace on online brokerage apps that present potentially risky trading capabilities, including options trading, to everyday investors.
Ultimately, the SEC, FINRA and other authorities will investigate and examine whether there is illegal conduct predicated on the dissemination of “false and material misinformation” or disinformation into the marketplace in an effort to wrongfully manipulate a stock price either up or down. We expect that certain public, high profile operators driving WSB and the “resistance” on GameStop and others, will be in the crosshairs, as will any short traders who did not comply with short trading regulations, and brokers if they acted in concert, preferring certain classes of investor customers over others. We expect to see significant information gathering and likely lots of subpoenas drawn out over a substantial period of time, but ultimately do not envision a substantial volume of enforcement proceedings — perhaps a few test “example” cases.
As is often the case when controversial, market developments take hold of the United States and global economy, different branches of Congress will investigate. We expect nothing less here.
Issues to be examined likely include:
- The practice of short selling generally.
- The impact of social media on the market.
- How “free” is free trading.
- Whether investors need or want the sort of “protection” being debated, or is all fair in love, war and stock trading?
- An analysis on disclosure, market manipulation and potential fraud.
We expect, in time, there will be some rule-making adjustments after a substantial comments period surrounding: (i) the public disclosure of adverse short analysis, research and trading positions; (ii) how social media platforms like Reddit will be regulated concerning the stock market, and (iii) how broker dealers address notions of disclosure, transparency and access.
While betting against stock, by going short, has been met with concern and, at times, consternation, the question of whether short selling positions as an investment strategy, amongst sophisticated money managers, will soon become a distant memory remains an open one. We ultimately expect that rumors of the permanent demise of short selling will prove to be highly exaggerated — despite the billions in losses suffered last week.
Where Does it All End
We expect there will be lots of parallel regulatory and potentially criminal investigations and information gathering. But more importantly, as we often see with frauds of a Ponzi scheme variety, when the money runs out, the scheme collapses. Here, eventually these stocks being pumped up will crater and a large number of “ordinary” investors who tried to ride the wave or make quick money on these stocks, will suffer disproportionately, and in some instances, catastrophic losses when the prices of these stocks collapse. The damages caused when (and in our expectation not “if”) the trading prices for squeezed securities fall off the proverbial cliff, will be in the billions, which will intensify and perpetuate a vicious cycle of private litigation, efforts at regulatory enforcement, and legislative involvement to regulate, systemically, a free market.
We also expect ancillary trading markets such as virtual currencies (including bitcoin and the popular-as-of-late dogecoins), other digital assets and commodities like silver to see a much wider band, and be way more volatile in the face of the scrutiny now facing certain equities being shorted by institutional investors and squeezed by retail ones.
In short, with no plain end in sight, all should buckle their seatbelts. The drive is far from over, and there is a significant likelihood that the best and worst of this drama is still to come.
1 On January 4, 2021, GameStop (GME) and AMC (AMC) were trading at $19.00 and $2.20, respectively. By January 27, GME had surged to $483.00 a share while AMC peaked at $20.36.
2 The phrase “Send AMC to the Moon” trended on social media platforms after being posted by WSB.
3 For example, Melvin Capital was on these trades decimated suffering real-time losses of approximately $4.5 billion requiring an infusion of billions from investors such as Stevie Cohen.
4 For example, in direct response to being negatively caught up in the GameStop squeeze, long-time hedge fund analyst and well-known Wall Street “contrarian” Andrew Left, the founder of Citron Research, publicly announced that after 20 years of doing so, Citron will no longer publish short-selling research and reports and will instead focus its analysis on big, “long” opportunities for companies with core fundamentals such as strong management teams, ethical business practices, and business models that are forward thinking and socially conscious. While short selling is not illegal, “naked short selling” or the practice of short selling shares that have not been affirmatively determined to exist is against the law. See Securities and Exchange Commission, "Amendments to Regulation SHO," [Release No. 34-58773], Oct. 1, 2008.
5 Robinhood's website entitled Our Mission states, “Robinhood's mission is to democratize finance for all. We believe that everyone should have access to the financial markets, so we've built Robinhood from the ground up to make investing friendly, approachable, and understandable for newcomers and experts alike.” When interviewed on CNBC regarding the restricted trading, Robinhood CEO Vladimir Tenev stated, “We absolutely did not do this at the direction of any market maker or hedge fund. . . the reason we did it is because Robinhood as a brokerage firm, we have lots of financial requirements.”
6 Class actions against Robinhood were filed in federal courts across the country, including causes of action asserting (among other things) breach of contract, breach of implied covenant of good faith and fair dealing, breach of fiduciary duty, and common law negligence. (e.g. Austin Schaff v. Robinhood Markets, Inc et al, 8:21 cv 216 (M.D. Fla. 2021); Brendon Nelson v. Robinhood Financial LLC et al, 1:21 cv 777 (S.D. NY 2021) among others.)
7 The market “disruption” caused by trading and heavy “inflation” of stock prices of GameStop, as well as by Robinhood's decision-making, have not surprisingly caught the attention of legislators in DC including political sparring partners Representative Alexandria Ocasio-Cortez and Senator Ted Cruz, as well as the likes of Senator Elizabeth Warren. All have called for investigations and inquiries into the trading activities and volatility of last week, expressing concerns relating to the “free market,” aspects of the tension, as well as raising at least the specter under a Democratic President and Congress of significantly increased and heightened systemic regulation and enforcement policy as a way of, arguably, better protecting investors, from stock trading that is not being predicated on traditional notions of a company's actual “value.”
8 The SEC (and FINRA) will be looking at whether there was “illegal” trading based on false information being disseminated into the market place and trading practices, and broker execution practices. To date, the SEC has not yet invoked any sort of suspension of trading for ten business days under section 12 (K)(1)(a) of the Securities Exchange Act of 1934.
Originally Published by Buchanan Ingersoll, February 2021
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.