SEC v. WSB: The case of GME
A group of retail investors from around the world, connected by an online wiki-style social media platform collectively organized to systematically buy-and-hold specific securities with the goal of artificially increasing the share price, and costing large hedge funds with significant short-positions large amounts of money in losses.
The group self-named “r/WallStreetBets” (“WSB”) has been operating since 2012, and rapidly gained popularity the last few years due to many large brokerages eliminating or drastically trading commissions, making “day trading” at a profit more likely.
Historically, each trade cost about $5, and to complete a buy-sell requires two trades, leaving day trading to those who researched their trades, and had long term investment horizons. Once the fees fell away, the hesitation of retail investors to make less researched and planned trades increased as if things began to turn south, the fees involved with purchasing and selling a security no longer ate into profits or increased losses.
For better or for worse, intraday trading was no longer a game reserved for the financial big-wigs. The board was set for a standoff between retail and institutional investors, as wounds from 2008 wall-street greediness still haven't healed yet.
GameStop (NYSE: GME) is a retailer focusing on video game consoles, and the games themselves, while also providing a place for gamers to exchange games in return for store credit or small amounts of money. With the availability of digital downloads, the market for physical game discs has diminished, leaving GameStop’s key revenue driver to lose value. GameStop management responded by closing stores and cutting costs. Some investors are now seeing parallels between the video rental market that led to Blockbuster’s fall and the video game market that GameStop is in.
A telling indicator about the future of GameStop is how drastically it has reduced its full-time workforce. In 2017, the company ended the fiscal year with 23 thousand full-time employees, in 2019 it ended with 16 thousand full-time employees and in 2020 it ended with 14 thousand full-time employees. Some of the 2019-2020 layoffs were certainly due to COVID-19 pandemic cost-cutting but the 7 thousand full-time jobs cut in the previous 3 years does not tell a story of growth, rather of slowly winding down operations. e.
GameStop posted net losses of $673 million in the fiscal year 2019 (February 2018 - February 2019) and $470 million for the fiscal year 2020 (February 2019 - February 2020). The three years prior to 2019, net income had been falling from a high of 353 million in 2017 to a low in 2018 of 34 million.
This was the Wall Street Bets choose as a hill to die on; a barely solvent retailer in an area of the gaming industry shrinking year after year in favor of digital game delivery.
In the aftermath of the exponential rise of GME’s share price in the early months of 2021, many are left asking whether or not laws were broken by retail investors banding together, brokerages who limited trading of certain securities, or by the hedge funds with large shorting interest in the securities in question.
Robinhood, among others, limited users to sell-only transactions, in part due to the dramatic volatility that the security had, but also because in procedures where brokerages process orders on behalf of their users, the brokerage is required to deposit capital to process the transaction. This deposit is to allow a user to trade immediately with proceeds from the sale and without this deposit by RobbinHood its users would have to wait 2 days to have access to their proceeds from each transaction.
Normally, this isn’t an issue, but the deposit required by the clearinghouse intermediary increased exponentially due to the enormous volatility and risk that GME presented to the clearinghouse and Robinhood. Robinhood was unwilling (or unable) to deposit the required to continue to process buy transactions on behalf of their users, limiting them to sell-only transactions.
Some Robinhood users who felt they “missed out” on GME due to the sell-only restriction claimed that the actions were based on more sinister motives, citing the connection between hedge funds who had a sizable short interest in GME and the brokerage firm. Executives of both companies categorically denied any collusion to halt trading for reasons other than clearinghouse deposit in testimony before congress.
Retail investors banding together to artificially influence the price could be considered part of a ‘pump-and-dump’ scheme where either individual investors or a group of investors begin to spread false or misleading information about a stock with the aim to influence its price.
In a “pump-and-dump’, misleading or false information is used to encourage investors to purchase shares, driving the price up and the perpetrators then sell their shares at a profit, while leaving the investors who purchased shares at the high prices with huge losses when the reality of the situation emerges. In the example of GME, investors, who were buying shares at prices above $340 per share on the information from r/WSB that the stock was “going to the moon”, lost considerable amounts of money on each share when the price plummeted to $190 just days later. In a time when any person can post false information about a stock on the internet, these are more likely to happen and due to the worldwide reach of the information, the results can be disastrous for investors.
There are 4 elements outlined by US CFTC v. Wilson that must be must in order to conduct to be considered market manipulation. These are the elements that the Securities and Exchange Commission’s Enforcement Division is using to determine if there was wrongdoing by any party.
The first element of market manipulation is determining whether or not the investor had the ability to influence the market. Collectively, the WSB investors totaling 9.1 million clearly have some ability to influence the market. To illustrate the potential capital that could be deployed in aggregate if each of the WBS members invested $100 totals $910 million. The possibilities for market manipulation with amounts of capital that large are not hard to imagine, especially if the amounts on average were much higher than $100, as many of the posts on the forum show.
The second element of market manipulation is that there were artificial prices, which means that the prices of the security were not prices that reflected an efficient market. This condition is met by the price of GME reaching and exceeding $400 per share. This price had no basis in fundamental stock analysis or value-based investing strategy, and the broader market did not experience similar price increases.
The third element of market manipulation is the investors caused the artificial prices. The WSB members were the direct cause of the price increase due to their very vocal public collusion to “buy-and-hold” GME and waiting for the hedge funds who had large short interests to back out of their positions and increase the price. It’s unlikely that without WSB and the planning that went on in the Reddit board, GME (or any stock) would have moved any noticeable amount.
In other words, the WSB forum acted as a sort of control tower directing its members to purchase and hold the stock. This is key to the events involving GME, for, without it, there would have been no buying-and-holding frenzy leading to a short squeeze, further increasing the price. Narratives about not selling or else the hedge funds (as a proxy for Wall Street) would win are the key to why the price increased so rapidly.
The fourth and final element of determining whether there was market manipulation is whether the investors intended to cause the artificial prices. This condition is the hardest to prove, but based on discussions during the early days of GME’s rise where the sentiment seemed to be that this was not just for profits, but for revenge against Wall Street by wounding hedge funds who had significant short interests.
It’s likely that the group intended to harm the hedge funds and to accomplish that required an artificial price. Hedge funds cut their losses and covered their shorts by buying millions of shares, which due to the fact that WSB investors weren’t selling, dramatically increased the price the hedge funds had to pay per share. This would have been the optimal point for the perpetrators to sell, as the price was at its theoretical maximum due to the perfect series of events occurring to increase the price.
In light of the likelihood of market manipulation, some brokerages proactively halted trading of GME and other “meme stocks” on their platforms to avoid another event like this in the short term. Halting trading of specific securities does not address the larger trends in the market where retail investors band together and move markets, something that has never been seen before in financial history.
So, it’s safe to say that Wall Street Bets engaged in market manipulation. But so what? The Securities and Exchange Commission doesn’t have the resources or will to investigate, indict, and prosecute 9.1 million members each for their part of the GME price pump. What they can do is investigate the top leaders of WSB, and hold them accountable for the market manipulation to which they were accessories.
The implications of this are numerous but can be divided into broad categories. First, Congress could direct the SEC to monitor markets for “meme stocks” and restrict their trading to small orders, limiting the rapid run-up potential of security. Second, Congress could direct the SEC to develop regulations for brokerages to self-monitor buying-and-selling activity and warn the SEC of large changes in volume or order sizes for potential “meme stocks." Third, and most likely to occur in some form is Congress will begin to hold social media platforms limit certain discussions about financial markets or at the very least ensure the SEC is aware of the discussions.
Information about an individual or institutional investor’s specific trades is available to the SEC. Using that information, investigators can determine if there was any unexpected buying and holding prior to the WSB posts about GME, and look at who sold when the stock was at its artificial prices. That information might provide a list of potential investors the SEC might sanction for their role in the scheme.
Currently, the SEC is conducting an investigation into the events leading up to the GME price run-up, but no announcements of charges or intent of charges have been made. The results of this investigation will set a precedent for how future crowd-sourced market manipulation schemes are treated.
Lawsuits against a frequent WSB poster and YouTuber “Roaring Kitty” who also goes by Keith Gill have been filed in Massachusetts Federal Court. These lawsuits claim Gill engaged in securities fraud when he promoted GME on his platform, saw the effect he was having on the market and continued to promote the trade.
The lawsuit was filed as a class action, meaning multiple investors who had losses as a result of his actions, are all claiming that he is responsible for their losses. The claims in this lawsuit are the same claims that are made in lawsuits against major white-collar criminals who manipulate markets.
Congresses House Financial Services Committee had a hearing into the events involving GME and invited Robinhood CEO Vlad Tenev, Citadel Securities founder Ken Griffin, WSB poster Keith Grill, Reddit CEO Steve Huffman, and Melvin Capital CEO Gabe Plotkin.
The hearing explored some of the key issues in the events, focusing on WSB and the intent of Keith Grill, who maintains that he still “likes the stock” and thinks that is “currently undervalued”. The committee report has yet to be released, but from the testimony given, the results of the report will likely acquit Robinhood of wrongdoing and shift the focus to r/WallStreetBets’ role in the volatility.
The saga that started with GME is not over yet. The SEC limited trading of 15 other stocks on February 26th that it decided were in violation of various market manipulation laws due to their widespread promotion on social media.
The results of the SEC investigation into GME and other “meme stocks” will be precedent-setting and could forever change the landscape of retail investors posting investment tips as well as the outlook for efficient capital markets.