In January and February of 2021, as the world continued to struggle through the COVID-19 pandemic, the United States’ stock market experienced its own unprecedented event. A group of retail investors who were active participants on r/wallstreetbets, a thread on the social networking website Reddit, became aware that several large hedge funds held extreme short positions in GameStop stock ($GME).1. Armed with this knowledge, these retail investors used social media to encourage other retail investors to buy $GME, as well as other heavily-shorted stocks, in an effort to trigger a short squeeze.2. A short squeeze occurs when, as a result of a stock’s increasing price, entities that hold a short position in that stock are forced to buy the stock to cap their losses, thus applying even more upward pressure on the stock’s price.3. The “David-versus-Goliath” perception of a bunch of retail traders sticking it to massive hedge funds quickly went viral, and led to an even greater number of retail investors buying $GME and the other stocks that were targeted by r/wallstreetbets investors.4. In the end, the surge of retail purchases of $GME skyrocketed the stock price up more than 1700% and several hedge funds suffered great losses as a result. However, after several days, the stock price fell back down to several multiples above its pre-viral price.5.
The market volatility produced by this influx of retail trading in targeted stocks has led regulators, including the SEC and Treasury Secretary, to question whether the retail investors violated any stock manipulation laws and whether regulators should promulgate any new regulations to protect both investors and the underlying integrity of the stock market.6. This blog post will seek to explain modern stock manipulation laws, and analyze their applicability to social-media fueled stock bubbles, such as the one that just occurred with $GME.
Modern anti-manipulation law can be traced back to the Securities Exchange Act of 1934.7. Section 9(a)(2) of the Securities Exchange Act outlaws manipulation in the form of “a series of transactions” that create “actual or apparent active trading” or impact “the price of such security for the purpose of inducing the purchase or sale of such security by others.”8. Section 10(b) directly invokes the term manipulation, prohibiting the “use or employ, in connection with the purchase or sale of any security…any manipulative or deceptive device or contrivance in contravention of” SEC “rules and regulations.”9. While there are many questions that these provisions leave unanswered, such as how “manipulative” should be defined under section 10(b), or how we should evaluate a trader’s purpose for engaging in any given trade under section 9(a)(2), they nonetheless provide the foundation for all modern theories of stock manipulation in the US.10.
Scholars have used the limitations established by the Securities Exchange Act to identify three distinct categories, or types, of stock market manipulation: 1) naked open market manipulation, 2) open market manipulation with an external interest, and 3) misstatement manipulation.11.
Naked open market manipulation “involves the purchase of a number of shares, with an upward push on prices, and then their resale under circumstances in which the corresponding downward push on prices is less severe, thereby resulting in the average sale price exceeding the average purchase price.”12. In other words, this type of manipulation occurs when a trader identifies a stock where one side of the market is more price inelastic than the other side. If, for example, the buy side of the market for a given stock is more price sensitive at any given time than the sell side of the market for that stock, a trader can buy stock, causing the purchase price to increase, and when that trader sells the stock, the sale price will not decrease as much as the purchase price increased. This asymmetric price response yields positive profits.13. It does not appear that the social-media-induced $GME bubble is compatible with naked open market manipulation trading methods.
Open market manipulation with an external interest “involves a trader that has some kind of economic interest in the price of a security independent of the price at which she can buy and sell it on the open market.”14. The most common example of this type of manipulation is when corporate executives have compensation packages that are tied to their company’s stock price at a specific point in time.15. An executive could buy stock right before their contract incentive is triggered, thus increasing the stock price and increasing the value of their incentive.16. It is impossible to assess whether this type of manipulation occurred without knowing more about the financial information of the retail traders who were involved in making $GME go viral.
Misstatement manipulation, commonly associated with pump and dump schemes17, “involves a trader who makes a materially false…statement concerning an issuer” that pushes the issuer’s stock price in a favorable direction for the trader, who then profits off of this altered stock price.18. Misstatement manipulation is most akin to insider trading, in that a trader is using information that is not publicly available in order to impact stock price in a profit-seeking way, with the key distinction being that unlike with most insider trading, a misstatement manipulator uses false information.
The SEC has warned investors since at least 2015 that social media is a potent tool for stock manipulators, especially relative to pump and dump schemes.19. The manipulators’ ability to anonymously spread information quickly using the internet and social media, and to have that information instantly available to a large number of people, presents a great opportunity to would-be fraudsters.20. With this in mind, the events that led to the $GME bubble, if manipulative, most closely resemble misstatement manipulation.
However, while the $GME bubble was sparked by social media21, that alone does not mean that misstatement manipulation occurred. To prove that misstatement manipulation occurred under either §9(a)(2) or §10(b), one must prove that the manipulator intentionally committed a manipulative act.22. According to Gabriel Rauterberg, a Professor at the University of Michigan Law School who specializes in securities law, “the federal courts disagree a lot about what constitutes a manipulative act.”23. As a result, Professor Rauterberg claims that in order to be guilty of manipulation under the Securities and Exchange Act, r/wallstreetbets traders would have had to promulgate materially and objectively false information about $GME, with the intent of getting other investors to trade on that information.24. Professor Rauterberg points out that, given the trading momentum that $GME had, paired with the fact that many traders acknowledged that the fundamental value of $GME was unrelated to its skyrocketing share price, “manipulation could be hard to prove.”25. In other words, while it is clear that retail traders impacted the stock price, “manipulation law doesn’t make it illegal for you to cause a stock price to deviate from its fundamental value.”26.
The higher bar of proving intent to manipulate, as required by the Securities Exchange Act, is likely to be an elusive goal for prosecutors. This is especially true when one considers the mostly decentralized nature of viral, social media-fueled trading sentiments.27. Unlike other SEC enforcement actions for misstatement manipulation28, the viral nature of the $GME bubble makes it difficult for the SEC to trace the volatility in stock price back to any given set of statements made by any given trader.29. However, while U.S. regulators are still investigating whether any illegal manipulation took place relative to $GME30. E.U. regulators have gone one step further and positively stated that “coordinated strategies to buy and sell at certain conditions and at a certain point in time with the objective to inflate the share’s price,” such as targeting stocks that have “large short sale positions…could constitute market manipulation.”31.
Given the difficulty of proving intent to manipulate in the context of viral retail trading, how can regulators address this issue in the future to ensure stock manipulation doesn’t occur? One possible solution for differentiating between noncriminal social media hype around a given stock and criminal stock manipulation is to engage in a statistical analysis, analyzing the relationship between certain specific statements made on social media, and corresponding changes in trading activity.32. One such study successfully differentiated between “overoptimistic noise traders” and “overreaction[s] to news” from “pump and dumb scheme” manipulation.33. With this in mind, one potential solution could be for regulators to bolster their ability to monitor and analyze social media mentions of stocks and corresponding shifts in trading activity in real time. Regardless of how US regulators choose to address retail trader manipulation, the increasing ease of retail trading and the viral nature of social media all but ensure this problem with continue to grow in the future.
Matt Phillips and Taylor Lorenz, ‘Dumb Money’ Is on GameStop, and It’s Beating Wall Street at Its Own Game, N.Y. Times (Feb. 1, 2021), https://www.nytimes.com/2021/01/27/business/gamestop-wall-street-bets.html. ↩
Phillips & Lorenz, supra note 1. ↩
Phillips & Lorenz, supra note 1 ↩
Jeanna Smialek and Deborah Solomon, Yellen and Regulators Met Amid GameStop Frenzy to Discuss Market Volatility, N.Y. Times (Feb. 4, 2021), https://www.nytimes.com/2021/02/04/business/economy/yellen-gamestop.html?action=click&auth=linked-google&context=styln-gamestop-catchup&module=styln-gamestop&pgtype=Article®ion=MAIN_CONTENT_1&state=default.) ↩
Merritt B. Fox, Lawrence R. Glosten & Gabriel V. Rauterberg, The New Stock Market: Law, Economics, and Policy 200 (1st ed. 2019). ↩
15 U.S.C.A. § 78i (West 2021). ↩
15 U.S.C.A. § 78j (West 2021). ↩
Fox, Glosten & Rauterberg, supra note 7, at 201. ↩
Id. at 203-05. ↩
Fox, Glosten & Rauterberg, supra note 7, at 203. ↩
Id. at 204. ↩
Id. at 204. ↩
Fox, Glosten & Rauterberg, supra note 7, at 204. ↩
Press Release, SEC Office of Investor Education and Advocacy, Updated Investor Alert: Social media and Investing — Stock Rumors (Nov. 5, 2015), https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-alerts/updated-1 [hereinafter Investor Alert] ↩
Fox, Glosten & Rauterberg, supra note 7, at 205. ↩
Investor Alert, supra note 18. ↩
Phillips & Lorenz, supra note 1. ↩
Fox, Glosten & Rauterberg, supra note 7, at 205. ↩
Alex Vuocolo, Market Manipulation in GameStop Case Hard to Prove, Says Legal Expert, Cheddar (Feb. 2, 2021), https://cheddar.com/media/market-manipulation-in-gamestop-case-hard-to-prove-says-legal-expert; see also Fox, Glosten & Rauterberg, supra note 7, at 233. ↩
Vuocolo, supra note 24. ↩
Vuocolo, supra note 24. ↩
Press Release, SEC, SEC Charges: False Tweets Sent Two Stocks Reeling in Market Manipulation (Nov. 5, 2015), https://www.sec.gov/news/pressrelease/2015-254.html (describing an SEC enforcement action brought against a single retail trader who used social media to spread materially false information about two different publicly traded companies that triggered large price movements in both companies’ stocks ↩
Reuters Staff, SEC Studies Social Media Posts for Signs of Fraud in GameStop Frenzy: Bloomberg, Reuters (Feb. 3, 2021), https://www.reuters.com/article/us-retail-trading-gamestop/sec-studies-social-media-posts-for-signs-of-fraud-in-gamestop-frenzy-bloomberg-idUSKBN2A32XT.) ↩
Steven Maijoor, European Sec. and Mkts. Auth., ECON Exchange of Views in Relation to GameStop Share Trading and Related Phenomena 3 (2021), https://www.esma.europa.eu/sites/default/files/library/esma22-105-1307_introductory_statement_on_gamestop_share_trading_-_steven_maijoor.pdf. ↩
Thomas Renault, Market Manipulation and Suspicious Stock Recommendations on Social Media, 1, 1-3 (2017), https://poseidon01.ssrn.com/delivery.php?ID=108065093065091090002124072079031067032037017041086025023086001065083081064100001030057099100122006004105113092005000073127070116038000015045100090102075092082102089004055022112112065098075009116081064125096065024112106109081105089069110122096089098085&EXT=pdf&INDEX=TRUE. ↩
Id. at 2. ↩