What Is the SEC Going To Do About GameStop?
2.4.2021
The coronavirus pandemic, a civil rights movement and raging political turmoil marked the year 2020. Now, less than a month into 2021, another societal shift has impacted the financial markets. GameStop Corp., a nearly defunct brick-and-mortar video game retailer, quickly became the center of the financial world when its stock was influenced in a manner never before seen. Internet retail investors publicly joined together in an attempt to undermine a hedge fund that had shorted the GameStop stock (GME). Then unexpectedly, the Robinhood Financial, LLC trading platform brazenly restricted the purchase orders of GME, triggering public outcry from politicians, celebrities and government agencies alike. This article is a reflection on the GameStop saga and a look into the potential federal securities law violations of the various players’ bizarre and novel actions.
Background: GameStop, Wallstreetbets and Robinhood
At the center of the GameStop saga is the website Reddit.com. Reddit is a popular website that self-proclaims it “powers hundreds of thousands of distinct online communities”[1] through the use of small forum-type discussion boards that are referred to as “subreddits.” One such subreddit, aptly named “Wallstreetbets,”[2] caters to the stock market investing community.
On the other side of the table from Wallstreetbets sits Melvin Capital Management LP, a billion-dollar hedge fund.[3] For reasons that are not clear, many Wallstreetbets users developed a vendetta against Melvin Capital. On November 16, 2020, Melvin Capital filed a Form 13F disclosure filing with the SEC that revealed it had a short position in GME.[4] Wallstreetbets discovered the disclosure and contrived a plan to enact a “short squeeze”[5] on the Melvin Capital position by raising GME’s price through a coordinated stock purchasing campaign. Due to Melvin Capital’s short position,[6] any increase in the price of GME could cause losses for Melvin Capital.
By Wednesday, January 27, GME’s price had precipitously climbed from roughly $12 per share on November 16, 2020, to roughly $380 per share. As a result of its short position, Melvin Capital started incurring exorbitant losses. It was soon reported that Melvin Capital was having liquidity issues and had to reach out to other hedge funds in order to obtain loans to support its short position.[7] Wallstreetbets’ plan was working.
On the morning of Thursday, January 28, Wallstreetbets, along with countless retail investors, once again set out to maintain and increase their GME positions; however, Robinhood restricted the purchasing of GME on its platform.[8] Without the Robinhood investors’ ability to purchase additional shares of GameStop, Wallstreetbets could not continue with the short squeeze. Instead, the Robinhood investors were left with only the ability to sell their positions, and the price of GME plummeted.
Robinhood announced that the unprecedented move was done as a result of the “extraordinary circumstances in the market” and cited SEC net capital obligations as one of the contributing motivating factors.[9] However, this announcement was met with furious public outcry claiming that the net capital excuse was a farce. Celebrities, politicians (on both sides of the aisle), Wallstreetbets and retail investors alike all called for the Securities and Exchange Commission (SEC) to step in and address what had been speculated to be market manipulation and illicit conduct on behalf of Robinhood.
Potential Federal Securities Law Violations of Wallstreetbets
The Wallstreetbets subreddit was responsible for inciting a massive number of retail investors to purchase a specific security, in a coordinated effort, in order to influence the price of the security, all the while undermining a hedge fund. The possible legal implications for these actions are broad, but in the eyes of the SEC, a case could most debatably be made for either market manipulation or a disclosure violation.
Wallstreetbets’ Potential Market Manipulation Liability – Manipulating or Influencing?
The SEC addresses this type of pricing market manipulation in Section 9(a)(2) of the Securities Exchange Act of 1934:
“(a) Transactions relating to purchase or sale of security
It shall be unlawful for any person . . .
(2) To effect, alone or with 1 or more other persons, a series of transactions in any security registered on a national securities exchange . . . creating actual or apparent active trading in such security, or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.” 15 U.S.C.A. § 78i.
Here, Wallstreetbets was arguably responsible for coordinating a massive GME purchasing campaign, which increased the price of the shares dramatically. Those actions did influence the price of the GME shares. However, these actions alone cannot amount to market manipulation without also being accompanied by the requisite state of mind.
Section 9(a)(2) of the Exchange Act is a scienter-based cause of action, which means the actor must have “a mental state embracing intent to deceive, manipulate, or defraud.”[10] In this context, intent would also imply intent to create an artificial demand for the stock.[11] Artificial demand can be created through any number of misleading practices including wash sales, matched orders, and rigged prices.[12] These manipulative practices “artificially affect[] market activity in order to mislead investors.”[13] Wallstreetbets did not create artificial demand but instead an exorbitant amount of organic demand. Without illicit intent, no illegal market manipulation can occur.
Wallstreetbets’ Potential Beneficial Ownership and Disclosure Violation Liability: Group or a Movement?
In addition to evaluating the Wallstreetbets’ trading activity as market manipulation, it is also important to consider whether Wallstreetbets’ conduct necessitated disclosures. If the Wallstreetbets traders were considered to be part of a group, then they could be required to make certain disclosures. Section 13(d) of the Exchange Act sets forth this requirement:
“(d) Reports by persons acquiring more than five per centum of certain classes of securities . . .
(1) Any person who, after acquiring directly or indirectly . . . or is deemed to become a beneficial owner of . . . more than 5 per centum of such class shall . . . file with the Commission, a statement. . .
(3) When two or more persons act as a . . . group for the purpose of acquiring, holding, or disposing of securities . . .” 15 U.S.C.A. § 78m (emphasis added).
Section 13(d) disclosures are required when an individual, or a group of individuals, has acquired, in aggregate, more than 5% of a company’s shares. If the Wallstreetbets traders’ total share ownership of GME surpassed 5% at any time, then a disclosure could have been required. Moreover, Section 13(d) of the Exchange Act is also a non-scienter-based cause of action, so unlike with market manipulation intent is not required.
Absent an agreement to enter into a group, a determination of a group cannot be made.[14] However, courts have held that the touchstone of a group is that “the members combined in furtherance of a common objective”[15] and that the formation of a group “may be formal or informal.”[16] Still, barring the discovery of an agreement between the Wallstreetbets traders, no Section 13(d) disclosures are likely to have been necessary. Hypothetically, if the Wallstreetbets traders did enter into agreements, then they could foreseeably face disclosure liability.
Potential Federal Securities Law Violations of Robinhood
On Thursday, January 28, 2021, when Robinhood restricted the purchases of GME, it announced that it had done so in an attempt to adhere to SEC net capital requirements.[17] Regardless of these reportedly genuine motives, Robinhood’s actions have been met with class-action lawsuits and public distrust. The SEC was also pressured to put out a public statement, which noted that “[t]he Commission will closely review actions taken by regulated entities that may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities,” seemingly in direct response to Robinhood’s actions.[18]
Hypothetically, if Robinhood had restricted the purchase of GME shares as part of a deceptive, manipulative or fraudulent plan to lower its price, then Robinhood could also be looked at for market manipulation. In this hypothetical evaluation, Robinhood’s actions could easily be seen as a means to artificially influence the price of GME. This type of conduct could very well result in a violation of Section 9(a)(2) of the Exchange Act as a type of market manipulation. These actions could also likely establish a violation of Section 10(b) of the Exchange Act and Rule 10b-5, which is the federal securities law’s broadest anti-fraud provision.
The GameStop Saga’s Impact on the Financial Markets
The SEC has stated that market manipulation could hardly be more serious because it “attacks the very foundation and integrity of the free market system.”[19] Only time will tell if the SEC brings an enforcement action against one of the parties discussed above. However, in large part, the damage that has already been done to investor confidence is permanent. Wallstreetbets shows us a glimpse into the future of social- media-fueled investing. We can only hope these market participants weren’t scorned by this experience just as quickly as their infatuation began.
Joshua F. Bautz is a securities litigation attorney licensed in Florida and New York. He works at the law firm of Sallah, Astarita & Cox.
[1]. Reddit User Agreement, Reddit, https://www.redditinc.com/policies .
[2]. r/wallstreetbets, Reddit, https://www.reddit.com/r/wallstreetbets (description states “[l]ike 4chan found a Bloomberg terminal”).
[3]. Melvin Capital, https://melvincapital.com (website states “The firm uses a bottom-up, fundamental research-driven process to identify investments employing a long-short equity strategy”).
[4]. Electronic Data Gathering, Analysis, and Retrieval system, SEC, https://www.sec.gov/Archives/edgar/data/1628110/000090571820001111/xslForm13F_X01/infotable.xml.
[5]. Short Squeeze, Investopedia, https://www.investopedia.com/terms/s/shortsqueeze.asp (“A short squeeze occurs when a stock or other asset jumps sharply higher, forcing traders who had bet that its price would fall, to buy it in order to forestall even greater losses.”).
[6]. Short (Short Position), Investopedia, https://www.investopedia.com/terms/s/short.asp (“A short, or a short position, is created when a trader sells a security first with the intention of repurchasing it or covering it later at a lower price. A trader may decide to short a security when she believes that the price of that security is likely to decrease in the near future.”).
[7]. Melvin Capital, Hedge Fund Targeted by Reddit Board, Closes out of GameStop, CNBC, https://www.cnbc.com/2021/01/27/hedge-fund-targeted-by-reddit-board-melvin-capital-closed-out-of-gamestop-short-position-tuesday.html (last visited Jan. 31, 2021).
[8]. An Update on Market Volatility, blog.robinhood, https://blog.robinhood.com/news/2021/1/28/an-update-on-market-volatility (last visited Jan. 31, 2021).
[9]. Id.
[10]. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976).
[11]. Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 480 F.2d 341, 383 (2d Cir. 1973).
[12]. Santa Fe Indus. v. Green, 430 U.S. 462, 476 (1977).
[13]. Green, 430 U.S. at 477.
[14]. Corenco Corp. v. Schiavone & Sons, Inc., 488 F.2d 207, 217 (2d Cir. 1973).
[15]. Wellman v. Dickinson, 682 F.2d 355, 363 (2d Cir. 1982).
[16]. Morales v. Quintel Entm’t, Inc., 249 F.3d 115, 124 (2d Cir. 2001).
[17]. An Update on Market Volatility, blog.robinhood, https://blog.robinhood.com/news/2021/1/28/an-update-on-market-volatility (last visited Jan. 31, 2021).
[18]. Statement of Acting Chair Lee and Commissioners Peirce, Roisman, and Crenshaw Regarding Recent Market Volatility, SEC, https://www.sec.gov/news/public-statement/joint-statement-market-volatility-2021-01-29 (last visited Jan. 31, 2021).
[19]. In the Matter of Pagel, Inc., SEC Release No. 34-22280 (Aug. 1, 1985); 33 S.E.C. Docket 1003.
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