Practical Pieces & Perspectives
On January 22, 2021, when the Standards and Poor 500 Index grew by one dollar, GameStop Corp.’s stock price rose by $33.73 to a high of $76.76 before closing at $65.01.[2] And the surge did not stop there. After the weekend (the 22nd was a Friday), GameStop opened 52 percent above its previous closing price and rose another 40 percent—to a high of $159.18.[3] The following two days only added rocket fuel to GameStop moon-bound propulsion. On January 27, the closing price was $347.51.[4] The rapid price movements and high trading volumes triggered multiple instances of the New York Stock Exchange’s 5-minute trade suspension policy against its shares. [5]
So, what happened to GameStop? Market observers call it a short squeeze—a phenomena brought on by over exposed short sellers.[6] A short seller is an investor who borrows shares of a security and sells them at market value, agreeing to buy back the shares at a later price.[7] If stock prices fall, as hoped, then the short seller profits from the difference between what the stock was originally sold at and the lower amount at which it was repurchased.[8] If the stock price rises, the short seller’s losses are potentially infinite.[9] That is when a short squeeze can occur. The short seller must buy back the shares to cover their loans, further increasing the price and forcing other short sellers to exit their position as well—in a cannibalistic self-immolation.[10]
However, not all short squeezes are made equal. In GameStop’s case, Wall Street’s largest hedge funds, being able to take short positions on margin, managed to short 140 percent of GameStop’s market capitalization by the Fall of 2020.[11] Retail investors, empowered by commission-free trading platforms and modern social media outlets, took notice.[12] Specifically, a Reddit community known as Wall Street Bets (“WSB”) began discussing individually purchasing GameStop shares, and its members did just that.[13] Their efforts led to a 1,700 percent increase in the stock price from its summer 2020 levels, squeezing the overexposed short sellers out of their positions.[14] As GameStop’s prices fluctuated, WSB members “urged their peers to ‘hold the line.’”[15] Market observers, hedge fund managers and analysts began accusing the retails investors of market manipulation. On January 29, the Securities and Exchange Commission (“SEC”) took note and “said . . . that it would examine whether any traders manipulated prices by exhorting others on social-media websites to buy” GameStop and other “trendy stocks.”[16]
Penalty against market manipulations is administered under Section 9(a)(2) of the Securities and Exchange Act (the “Act”).[17] The congressional intent was to ensure that market prices reflected actual supply and demand of the underlying securities.[18] In relevant part, Section 9(a)(2) makes it unlawful:
To effect, alone or with one or more other persons, a series of transaction in any security registered on a national securities exchange creating actual or apparent active trading in such security or raising or depressing he price of such security, for the purpose of inducing the purchase or sale of such security by others.[19]
The statutory elements are “aimed at preventing . . . one-sided market” trades conducted at the “detriment of the investing public.”[20] There are two basic requirements to establish a violation.[21] First, there must be a series of transactions that either (1) creates real or apparent trading in the shares or (2) raises or depresses the share price.[22] And second, violators must act with “the purpose of inducing the sale or purchase of [shares] by others.”[23]
In Crane Co. v. Westinghouse Air Brake, a company (“Company A”) sought to force a merger with another company (“Company B”) by making a tender offer for shares directly to the shareholders.[24] The offer had a set price and expiration date.[25] The shareholders could wait “until the last moment . . . to make a decision” and thus, the best “way to defeat the” acquisition was to drive up the market price above the offer price.[26] Company B enlisted a third-party (“Company C”) to buy shares—at a loss—on the expiration date.[27] However, Company B and Company C secretly agreed to sell the purchased shares “off the market.” [28]
The court held that a Section 9(a)(2) violation had occurred. [29] In applying Section 9(a)(2) “to the relatively new device of the tender offer, rarely used before 1965,” the court looked to the section’s congressional intent. [30] The court noted:
Section 9(a)(2) was considered to be ‘the very heart of the act’ and its purpose was to outlaw every device ‘used to persuade the public that activity in a security is the reflection of a genuine demand instead of a mirage.’ [citation] Sections 9(a)(2) and 9(e) contain requirements of both manipulative motive and willfulness. The section does not condemn extensive buying or buying which raises the price of a security in itself. Nor are the requirements of manipulative purpose and willfulness to be interpreted apart from the statute’s design to prevent those with a financial interest in a security from manipulating the market therein. The requisite purpose and willfulness is [sic] normally inferred from the circumstances of the case. [31]
“A specific purpose to manipulate a security is [therefore] required to establish a violation of the section.”[32] Since Crane Co., the Supreme Court has held “that the term ‘manipulative’ as used in” the context of the Act “requires misrepresentation or nondisclosure.”[33] There must be “conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities.”[34]
In Crane Co., Company C had a “[pecuniary] interest in defeating the . . . tender offer” because it wanted to “consummat[e] its own merger with” Company B.[35] Accordingly, it purchased a large amount of shares, successfully increasing the price and defeating the offer. [36] Company C’s behavior however “was not consistent with the normal desire of an investor to buy at as low a price as possible.” [37] The “extraordinary buying . . . , coupled with [the] large secret sales off the market inevitably distorted the market picture and deceived public investors, particularly [the] shareholders” to whom the offer was made.[38] Unbeknownst to the shareholders, the stock price only reflected one side of Company C’s trades and did not reflect the “secret private sales off the stock exchange.”[39] In light of the “substantial direct pecuniary interest in the success of” the tender offer,[40] a prima facie case for finding a manipulative purpose “was manifest from the secret deals and the intentional loss taken by [Company C] to defeat” the offer.[41]
Crane Co. is however a rare case, serving as an egregious example against which most defendants are inevitably compared. [42] It sets a high bar—making a claim against WSB or its members unlikely to succeed. The key take away is that there must be an intent to distort a company’s share price,[43] or to “deceive or defraud investors.”[44] The picture in regard to GameStop was not due to any conduct designed to distort the market value or deceive public investors. The catalyst for GameStop’s meteoric rise was WSB’s belief that the company’s financial characteristic and share price did not account for its long-term viability in light of recent changes in board membership.[45] These changes and recent reportings’ initially fueled demand for the shares.[46] More retail investors purchase the stock as the price increased, however as Crane Co. noted: Section 9(a)(2) “does not condemn extensive buying or buying which raises the price of a security in itself.”[47] Moreover, as prices increased, over-leveraged short sellers were forced to cover their positions and put the short squeeze in full swing.[48] Undoubtedly, GameStop’s price was distorted, but this distortion was a product of the short sellers scrambling to cover their positions, not market manipulation.
On February 4th, GameStop shares closed at $53.50, falling 42 percent below its previous closing price and having four consecutive days of price decrease.[49] In all likelihood, the short squeeze is winding down. The market consequences and the lessons therefrom, however, may have far reaching implications.[50] Social media will continue to have a significant role in society and the markets. It “has become a more important driver in retail investing” as financial technology eliminates trading commissions and increases the number of inexperienced investors with higher than usual “tolerance for losses.”[51] While the SEC will need to adapt to these changes, it should also be cognizant of the tools that are available to regulate the markets. Section 9’s broader provisions empower the SEC to make rules regulating the endorsement of securities and derivative instrument.[52] Moreover, the SEC can prosecute ordinary securities fraud under Section 10(b) of the Securities Exchange Act of 1934.[53] However, it should approach regulating social media with caution as such regulations may raise some serious First Amendment concerns. As for the GameStop saga, without artificial distortion or intentional misrepresentation, Section 9(a)(2)’s prohibition against market manipulation likely does not apply to GameStop’s short squeeze.