Loyola University Chicago School of Law, Weekend JD 2023
GameStop started 2021 with a stock price below $20 but saw its stock price skyrocket to well above $300 a share towards the end of January. The rally would be hard to explain by solely relying on the company’s financial reports or underlying fundamentals. Instead, the rally has to be explained through a combination of external factors involving a popular fintech company’s app, manic speculation by retail investors, and Reddit. Although at first glance this may seem like a new phenomenon, the same factors have been at play for years with a huge interest in Tesla and Bitcoin – and they pose a risk to the markets that regulators and Wall Street together can’t ignore.
The massively multiplayer online investment war
Towards the end of 2020, activist investor and co-founder of Chewy Ryan Cohen had invested in GameStop, calling for a strategic review of the company to revamp the slogging retailer’s outlook. That investment, which caused a modest increase in GameStop’s stock, was met by big bets against the company by a pair of large investment firms, Citron Research and Melvin Capital. The rest is history – a Reddit fueled rally from subreddit r/WallStreetBets brought in hordes of retail investors and caused shares to surge, with momentum maintained by tweets by billionaires Chamath Palihapitiya and Elon Musk, trapping the investment firms in a short squeeze. Estimated losses experienced by the investment firms and other short sellers run as high as $19 billion as of January 29, 2021.
The tug of war between retail investors and large investment firms is unprecedented and has left many looking for answers as to how it happened. Important to the story is the online brokerage Robinhood, a Silicon Valley based fintech company that offers commission free trading on an app. Robinhood has amassed over 13 million users, many of whom are young amateur stock traders. In the chaos of the GameStop saga, Robinhood fell under significant pressure due to the volatility and its regulatory obligations, leading the firm to tap credit lines from banks and raise over a billion dollars from its existing investors. Robinhood also controversially halted trading on GameStop and other related stocks such as the movie theater chain AMC, leading to accusations that Robinhood sought to protect Wall Street. Additionally, Congress is calling for hearings over the halted trading, and at least one class-action lawsuit has been filed. Robinhood, like most brokerage firms, has an arbitration clause in their customer agreement that prevents customers from suing them in court. Still, even if the courts don’t hear the case, the reputational damage suffered by Robinhood appears substantial.
Market manipulation, suitability rules, and disclosure requirements
Accusations of illegal conduct are flying on all sides, with many pundits calling the actions of retail investors inspired by reddit memes market manipulation, while others levy similar accusations on Robinhood and other brokerages that halted trading. Market manipulation is difficult to prove, however, and there is uncertainty around its very definition. The Securities Exchange Act defines market manipulation as “transactions which create an artificial price or maintain an artificial price for a tradable security,” but as Sen. Elizabeth Warren noted, the Securities Exchange Commission (“SEC”) has failed to provide guidance or rules as to what that means. Additionally, according to James Cox, a professor at Duke University School of Law specializing in securities regulation, it’s difficult to determine where “manipulation start[s] and when does trading on your own hunches and publicizing your hunches start?”
Beyond their alleged market manipulation, regulators and market participants ought to consider the obligations that Robinhood and other brokers have regarding disclosures and how suitable the financial products that their customers are trading. In addition to the SEC, brokerage firms are regulated by the Financial Industry Regulatory Authority (“FINRA”) and are subject to the FINRA’s suitability rule, which requires that firms must have a reasonable basis to believe that a recommended transaction or investment strategy is suitable for a customer, based on a number of factors including a customer’s investment experience and risk tolerance. Additionally, the SEC has adopted Regulation Best Interest (“Reg BI”) to clarify firms’ responsibilities to their customers to provide transparency to their customers, especially as related to conflicts of interest. Based on these rules, brokerage firms are generally required to approve customers’ trading accounts for higher risk products, such as the options and margin accounts that have been so prevalent in recent stock rallies. In practice, however, retail brokerage firms rely on customers self-attesting to their investment experience and risk tolerance. And while the firms tend to require an application for customers to access riskier products like options trading and margin, some firms make it easy for customers to adjust settings on their platforms on their profiles to gain access to the products they want to trade.
Reg BI and FINRA’s suitability rule are not equivalent to a fiduciary standard, but some state securities regulators do impose a fiduciary standard on brokerage firms. Massachusetts’ securities regulator is currently suing Robinhood for aggressively marketing to inexperienced investors and failing to protect customers and their assets, breaching the state’s higher fiduciary standard. The state alleges that Robinhood utilizes gamification techniques that encourage users to trade stocks and options incessantly – nearly 100 times per day on average in at least one case. The case was filed prior to the GameStop events, but recent events are sure to be relevant- especially when considering the amount of Robinhood customers with access to margin trading and options trading, with novice customers encouraged to update their profile after making some trades to access the riskier products in their app.
Meme stocks, cryptocurrencies, and fears of the bubble bursting
Many pundits and politicians have referred to the recent activity in the stock market as a casino, which is not an unfair observation to make given the circumstances. There has already been substantial concern that the market has kept growing rapidly through the pandemic, seemingly detached from the harsh realities faced by the economy. But while there are fears of a bubble arising out of GameStop’s $23 billion market value being inflated, other companies with popular internet followings like Tesla have reached market caps as high as $820 billion. Unlike GameStop, Tesla’s prospects are reasonably more optimistic, with new technology that could prove lucrative. Nonetheless, numerous analysts have considered Tesla dramatically overvalued, pointing out that the stock price appears to be driven more by speculative fervor than the company’s recent performance. Specifically, Tesla founder and CEO Elon Musk maintains a cult-like following on Reddit of his own. These phenomena have been referred to – whether it be Tesla or GameStop – as meme stocks, due to their value being linked to internet culture. As Elon Musk himself has tweeted, “Who controls the memes, controls the Universe.”
Much of the same criticism can just as easily be applied to cryptocurrencies. Unlike securities, cryptocurrencies are not inherently valuable outside of their use as an alternate form of currency, with some raising concerns that the unjustifiable gains seen from these meme stocks also apply to them. Bitcoin, the most popular cryptocurrency, has a market cap of over $600 billion, but is notoriously volatile – and Reddit-fueled rallies of a dog themed competitor to Bitcoin, Dogecoin, also occurred this month, increasing the value 600% in 24 hours to a market cap of over $9 billion. The frenzy around cryptocurrency is less new than the meme stocks, however- in December 2017, Bitcoin reached almost $20,000 per Bitcoin and was predicted to reach $142,000 before it crashed and hit a bottom of $6,200.
The simultaneous rallies around cryptocurrencies and meme stocks should have market analysts, market regulators, and Wall Street itself concerned about the health of the market as a whole. In the middle of a devastating pandemic, where unemployment peaked at 14.8% and was still elevated as of December, a market correction could hurt not only Wall Street, but Main Street. Given the huge speculation in simultaneous potential bubbles, there is a real risk of a market panic. Wall Street appears to be banking on either the retail investors losing steam or market regulators intervening to return conditions to normal, but the retail investors appear here to stay, at least as long as apps like Robinhood exist. In order to properly control the risks posed by large amounts of retail investors creating bubbles based off of social media activity, brokers should be doing more due diligence into the sophistication of their customers, and regulators should be more adamant on enforcing the rules.
The views expressed in this blog are those only of the author and not that of any employer.