Unless you have been living under a rock the past few weeks, you have no doubt heard about, noticed, read about, or perhaps participated in the full-blown lunacy that is the GameStop stock market frenzy. Here’s your 2-minute summary. There is a reddit messageboard called WallStreetBets that describes itself as “like 4chan found a Bloomberg terminal”, and whose members self-describe as “degenerates,” “apes,” “retards,” “autists,” [sic, sic, sic, and sic] and more [probably also more sic]. GameStop is a brick-and-mortar video game retailer that has not had a great last couple of years. On top of the decline of malls and physical stores in favor of online shopping more generally, the video game industry specifically has experienced a shift away from physical discs toward digital products – so really a one, two punch of (1) Amazon selling discs that GameStop would have sold, and (2) digital downloads replacing discs. Add to that the COVID-19 pandemic doubling down on the pain to physical stores, and especially malls, and you have a sense of what GameStop’s last several quarters have been like. It was losing money before COVID-19, and now it’s really losing money. Not a company with great long-term prospects, right? Well, Wall Street thought so, anyway. Betting against GameStop (“shorting” the stock) accordingly became one of Wall Street’s favorite pastimes. Sort of shooting fish in a barrel (one analyst described GameStop as the “whipping boy” of Wall Street). At one point the stock had dropped under $4 per share. In any event, about a year ago, a member of WallStreetBets (his username is “deepfuckingvalue” if that gives you a sense of the community (hereinafter DFV)) took a look at GameStop and decided that, although it might not be the next Google, it wasn’t as bad of a company as the “smart money” thought. He bought the stock (going “long”) and loudly broadcast his view. You can go back and watch his original videos; they’re heavily “value investing” oriented. He comments on the fundamentals of the company and analyzes it compared to the rest of the market, engages in technical analysis, and all kinds of other related things (this is important because “Value Investing” is often (correctly) described as antithetical to speculation – and this distinction will come to bear a little more sharply later). WallStreetBets ridiculed him for making such a stupid decision. For a while. And then… The stock started going up, little by little. Turns out DFV was actually pretty smart, and had correctly diagnosed the “not good, but not so bad after all” state of the company. Again, this is a textbook value investing play:
  • Analyze company
  • Determine it’s worth $X per share
  • Look at stock market
  • Discover stock market is only pricing it at 25% of $X
  • Buy shares
  • Wait for market to realize it was wrong
  • Sell shares
  • Profit
Some other things started happening. Ryan Cohen (cofounder of Chewy) acquired a major position in GameStop and joined the Board of Directors. The stock went up even more. And along the way, two things happened. One, the folks on WallStreetBets were, bit by bit, coming around to DFV’s point of view and buying the stock. Two, someone noticed that several major hedge funds had enormous, EXTREMELY aggressive (to the point of recklessness) short positions in GameStop (for a period, OVER 100% OF THE FLOAT!!). Q: OK, smarty pants. How can you short more than 100% of the float? Also, what is a float? A: The “float” of a stock is the number of shares available to trade (e.g., how many shares are floating around). I’ll explain shorting a little bit more later, but let’s say the float is ONE share. I borrow it and short sell it. Then someone else borrows that same share and short sells it. There are now two shares short, even though the float is only one. Seems weird right? BUT, recall Economics 101: lending expands the money supply. Same principle. Q: I don’t understand all this nonsense about short selling. ‘Splain it to me please. A: Read the other ” Red Q&A” section down a little ways if you really need to understand short selling. But, bottom line is that it is a bet against the stock of a company. The strategy of shorting stocks is very popular with Hedge Funds. And eventually, it turned into a full-on frenzy. Buying, buying, buying. The WallStreetBets subreddit was full of memes encouraging its members to buy and hold (and not just WallStreetBets; many others were getting in on the action, too). The price of the stock rose and rose, then rocketed to over $400 per share last week. There were various shenanigans at the $400 peak, including brokerage shut-downs, allegations of dirty tricks by the short hedge funds, and much more. Today, the stock is back down to around $90 per share. So, there’s your history of what happened. I want to take this opportunity to talk about some of the allegations levelled at DFV and the WallStreetBets community, from a legal perspective. Specifically, was this a “pump and dump” scheme? (spoiler alert: probably not), was this an illegal short squeeze? is a short squeeze always illegal? (spoiler alert: only illegal if you collude to manipulate), did anything else illegal happen here? (spoiler alert: maybe) and much more. So, first issue – was this an illegal “pump and dump”? (SPOILER ALERT: I seriously doubt it) Unfortunately, the SEC has not provided us with a brightline and particularized rule on “pump and dump.” You can read what the SEC has written about pump and dumps at investor.gov here. Or, you can read the SEC’s “your money” guidelines on pump and dumps here. If you’re underwhelmed by the lack of specificity and frustrating generality of the foregoing, you’re not crazy. Most common definitions include the use of false or misleading information to increase stock values, manipulating the public into buying more shares and driving the price up, while the fraudsters sell after the price rises. There are a couple of key elements there that I want to focus on:
  1. False or misleading information
  2. The fraudsters sell at the peak
As to the first part of this, “false or misleading information” – let’s consider what we know. In the case of GameStop, much of the information promoted on the WallStreetBets message board seems to fall into one of two buckets (A) value-based analysis of the stock that is true, or at the very least, a “good faith argument” or (B) memes and jokes (some of which are quite funny, many of which are borderline-incomprehensible, but few to none of which I’d classify as any kind of genuine argument or claim about stock value). If you go watch his video, the analysis (as mentioned at the beginning) is actually quite good, and quite typical of what you’d see from a “value investor” and – more to the point – even if you disagree with his thesis, he’s making real points based on real information; he’s not fabricating information or spreading falsehoods. This second bit raises the somewhat strange utterly absurd (and I cannot believe love that I’m about to type this following sentence) question of whether a joke meme can constitute the kind of false or misleading information required to support a pump and dump conviction. I would LOVE to read the brief making the case that a meme gorilla sitting in an emoji rocket ship with diamond emojis plastered all over it saying “HODL” and “Apes together strong” constitutes false and misleading information. If this happens, you can expect multiple blog articles just block-quoting sections of that brief, as they say, “for the lulz”. Anyway, here is a list of a few notable “pump and dumps” for your reading pleasure:
  • Jonathan Lebed Jonathan Lebed was the subject of a 2001 BBC documentary called The Future Just Happened. In 1999-2000, the 15-year old Lebed would purchase penny stocks, then promote them on internet chat rooms and message boards using a computer in his bedroom in Cedar Grove, New Jersey. Lebed is notable for being the first minor prosecuted by the SEC for a securities violation. Lebed ultimately settled with the SEC out of court, not admitting any wrongdoing. He forfeited approximately $285,000 in profit and interest he had made in 11 trades. Notably, he was allowed to keep approximately half a million dollars, and he now operates a firm that specializes in penny stocks.
  • Jordan Belfort Jordan Belfort is probably the most famous case of a pump and dump fraud, and one of the few people to serve “legit” prison time. This name will very likely be familiar to you from the Martin Scorsese film The Wolf of Wall Street starring Leonardo DiCaprio, Jonah Hill, Margot Robbie, and Matthew McConaughey. Jordan Belfort, through his firm Stratton Oakmont, defrauded investors of an estimated $200 million or more. He pled guilty to securities fraud, money laundering, and other crimes, and spend almost two years in prison, as well as paying $110 million in restitution (as with Lebed, he was allowed to keep a significant portion of his ill-gotten gains). He is now a motivational speaker.
  • Barry Minkow Some people have referred to Barry Minkow as the “Mark Zuckerberg of the ‘80s”. His aim was to take his company, ZZZZZ Best Inc. to the pinnacle of the market, becoming the “General Motors of carpet cleaning” and to that end took the company public in 1986. Unfortunately, the documents used to validate the company’s worth were almost entirely forged, and the company plummeted from $280 million in value to virtual worthlessness. Minkow went to prison for about seven years. I suppose he really liked the food, because he decided to visit prison again later, after making more fraudulent statements about a different company.
  • Enron While Enron engaged in many flavors of fraudulent activity, among them was a pump and dump scheme in 2001, wherein top executives of the company spammed bulletin boards with positive sentiment and spread false (positive) rumors about the stock. In concert with this, Enron also cooked its books to show significant profits and increase its stock price. But as with the rest, the ruse couldn’t continue, and Enron went bankrupt, causing massive losses to stockholders, creditors, employees, and more. Enron is notable as most pump and dumps take place with “penny stocks” – but Enron was among the bluest of the blue chip stocks of Wall Street, and a darling of many stock analysts. Go figure.
  • Park Financial Group In 2007, the SEC charged Park Financial Group, based in Winter Park, Florida, and its principal, Gordon Cantley in connection with their conduct in 2002-2003 related to the Pink Sheet-traded company Spear & Jackson Inc. You can read the press release here.
I am highly doubtful that the “degenerates” cheering on GME on WallStreetBets look much like any of these notable cases. Also, as of February 3, DFV is ostensibly not selling the majority of his position. Second issue – is this short squeeze illegal? (SPOILER ALERT: Again, almost certainly not) Q: Wait a second Ryan. You said going short was like “betting against” a stock. How can you even do that? You can’t buy NEGATIVE shares of stock? (can you???) What, do you just fly on out to Vegas and bet the casino that it will go down? A: OK, so… you kind of CAN buy negative shares of stock. Here’s how that works. I think that Stock X is going to go down. I go ask my friend (who owns Stock X) “can I borrow your share of Stock X?” After considering his options (ha) for a moment, he says “OK, but you have to pay me some interest, based on the market value of the share, every day, for as long as you are borrowing it. And also, if I get nervous and ask you to give it back, you have to give it back to me.” I consider his terms for a moment. “Deal” I say. He hands me his share of Stock X. I then immediately go down to the market and sell the share of Stock X for $5.00. I am now “short” on Stock X. If Stock X drops to $2.00 tomorrow, I will buy a share and go give it back to my friend, as promised, and I have made $3.00 (less interest paid to my friend) on the deal. If, on the other hand, the price of Stock X rises to $6.00 or $10.00, my interest will go up significantly, as will my price to return the share of Stock X to my friend. Q: Damn dude, that seems pretty risky. What if the price of the stock goes up? Like, way way way way way way up? A: Yes. It is risky. But it can also be tremendously profitable, and there is an argument to be made that it’s important for liquidity. Anyway, that thing you’re describing where the price of the stock skyrockets due to all the other shares of Stock X being bought up is called a short squeeze. Now that we’ve got that out of the way… I have heard some misinformation kicked around on this one a little bit, including a post on YCombinator’s news site that “Short squeezes are illegal. Any brokerage that knowingly allowed a short squeeze to continue without taking action, could have potentially massive legal liabilities. That is another explanation beyond the 2 day settlement window that Webull published.” – this is not accurate. Short squeezes are not per se illegal. One of the relevant pieces of guidance is SEC Regulation SHO (summary, full text).
7. Will close-out purchases required by Regulation SHO drive up a security’s price? Close-out purchases of stock will not necessarily drive up prices of such stocks. One of the primary purposes of Regulation SHO is to clean up open fail positions, but not to cause short squeezes. The term “short squeeze” refers to the pressure on short sellers to cover their positions as a result of sharp price increases or difficulty in borrowing the security the sellers are short. The rush by short sellers to cover produces additional upward pressure on the price of the stock, which then can cause an even greater squeeze. Although some short squeezes may occur naturally in the market, a scheme to manipulate the price or availability of stock in order to cause a short squeeze is illegal. [emphasis added]
From this, the question is: are a bunch of “degenerates” posting memes and urging one another to hold, and cause a short squeeze “a scheme to manipulate the price or availability of stock” – and again, to me it seems that the answer is almost certainly “no.” This is a group of people who noticed (loudly, and rudely) the EXISTENCE of an opportunity for a short squeeze. Some commentators have observed that “acting in collusion to buy the stock is illegal” – and that may be the case. Putting aside the fact that it’s basically impossible to make a statement like “WallStreetBets is saying X” because it is a disorganized and quasi-anarchic forum with no unified voice, one of the loudest messages being trumpeted on WallStreetBets was: “Hey guys, these Hedge Funds really overextended themselves and got reckless with their aggressive short position; there is an opportunity to make money here if you buy.” I don’t think that’s collusion or a “scheme to manipulate”; it’s the spreading of true market information. Almost anti-manipulation (is there a word for that?). The hedge funds did over-extend and get reckless with their short. There was an opportunity to make money for those who went long. There were other messages that got repeated and got a lot of traction like “My family lost everything in the 2008-2009 crash caused by the Hedge Funds; I am buying this stock solely to spite them, and I don’t care if I lose my investment.” Again, I don’t think that’s collusion or a scheme, but rather a statement of an individual’s position, beliefs, and intent. Collusion, on the other hand, would be  something like “I’ll buy if you buy, and then together we can artificially jack the price up and force this guy into a short squeeze.” (which, by the way, hedge funds, major companies, and ultrawealthy investors have absolutely done to each other over and over and over and over again, and the SEC hasn’t said much; so if there are any SEC enforcement actions initiated against the WallStreetBets crowd after all, I’m sure you’ll hear a lot about “rules for thee but not for me”). End of the day, in my opinion, the case for securities manipulation liability is pretty flimsy. But I suppose we’ll see. Third issue – did anything else illegal happen here? (SPOILER ALERT: maybe… stay tuned) Along the way of this wild, wild, ride, there have been a lot of rabbit trails and potentially shady things. As one example, the no-fee broker RobinHood (formerly, but no longer beloved by WallStreetBets) had a number of trading shutdowns during this ruckus whereby folks were allowed to buy a few shares of GME (and about 5 other stocks) – it varied from five shares, to two shares to one share. But (and here’s the interesting part) selling those stocks was unrestricted, and buying other stocks was unrestricted. A class action lawsuit was filed. Now, to be fair, there seems to be a potential explanation here. Brokers are highly regulated. There are certain capital requirements and reporting requirements that they must keep on the right side of. If trading gets too frenzied, brokerages may have to put limits on trading to protect themselves. This is all true. So, the innocent explanation of the trading stoppages is: RobinHood was just doing what it had to do for compliance purposes; if it had kept trading open, it would have run afoul of its legal and regulatory responsibilities. OK, fair enough. But, there is also a more nefarious explanation. RobinHood doesn’t charge a fee to trade, so how does the business make money? Well, they sell stock trade data to high-speed algorithmic trading platforms, who make money on frontrunning retail investors and harvesting pennies from each transaction. A firm (Citadel) executes orders placed by RobinHood and also buys a lot of that data. That same firm has a significant stake in a couple of the hedge funds who had their hands furthest down the over-aggressive GameStop short cookie jar. This is also all true. So, the nefarious explanation of the trading stoppages is: Citadel wanted to stem the bleeding on its balance sheet and leaned on RobinHood and other brokers to repeatedly circuit-break the stock on its way up so that the damage to the hedge funds would be less catastrophic. Does this ultimately hold water? Maybe. As a friend of mine once observed (in reference to an unrelated topic), “we all know that ‘golf course conversations’ happen, and you’ll never find a text or an email, but that conversation happened.” What we do know is that Congress is holding hearings. I guess we’ll see what kind of return on investment those campaign contributions are.