Enforcement & Litigation Are Next Stop After Furious GameStop Trading Leads to Platform Shutdowns

The feeding frenzy over GameStop stock, which fueled a market meltdown on Wednesday, has securities regulators investigating and lawmakers from both parties calling for action.

A woman wears a mask as she walks past a GameStop store in Des Plaines, Ill., on Oct. 15, 2020. (AP Photo/Nam Y. Huh)

MANHATTAN (CN) — Retail investors who feasted on GameStop shares the last few days to the detriment of Wall Street giants have caught the eye of lawmakers, regulators and securities attorneys.

The wild swings in the stock price — accomplished by a motley crew of retail investors and online pranksters pumping the value of GameStop — has already spurred popular retail investment platforms like Robinhood to rein in buying, but it could also lead regulators to crack down hard on retail investors.

Regulators could take myriad approaches to the mania, including placing curbs on certain stocks or even temporarily banning short sales on those stocks, said Mike Pagano, a finance professor at Villanova University. 

“If this swarm phenomenon continues, then more of these tools can be applied, along with enforcement actions on pump/dump traders and brokers that are shown to be aiding this type of behavior,” Pagano said in an email. “However, I think many regulators are hoping the bubble bursts on its own relatively quickly.”

The last few days have been a wild ride for GameStop, whose share price exploded from $20 per share a few weeks ago to more than $380 as of Wednesday morning. It has not been so good for several large hedge funds that had taken short positions, betting that GameStop’s stock was essentially a bubble and not priced accurately.

Many investment analysts had pegged GameStop as a dinosaur company. Despite rising video game demand in the age of Covid-19 lockdowns, the company operates as a brick-and-mortar, when many game companies are shifting to cloud-based and online game sales.

Message boards and chatrooms drove up intense interest, however, among investors in recent days. Some budding investors have hoped to make a quick buck or wanted to flex their contrarian muscles against the advice of Wall Street investment advisers. Others, though, have used the GameStop fiasco as an opportunity to take pot shots at the “global elite” and sink leveraged hedge funds.

“Stocks such as GameStop usually don’t move markets, but as is almost always the case, fears of contagion are starting to impact the broad market,” Tom Essaye of the Sevens Report wrote in an investor’s note early on Thursday.

He noted that the losses taken by large hedge funds could force liquidation in other parts of the market, leading to a “negative feedback loop” and a full-on pullback in equities.

“Bottom line, the GameStop fiasco has hit investor confidence, and given markets are stretched and investors complacent, it’s making the declines larger than they should be,” Essaye wrote.

The brunt of the GameStop rush was felt heaviest on Wednesday, when the three major U.S. indices saw their worst day in about three months. The Dow finished that day down 2%. 

On Thursday, after brokerages installed limits on the company’s stock, the opposite happened: GameStop dropped by about one-third to $230 a share and the Dow finished the day up about 1%. 

After the feeding frenzy, the Securities and Exchange Commission on Wednesday issued a statement that it was “actively monitoring the ongoing market volatility” and was “working with our fellow regulators to assess the situation and review the activities of regulated entities, financial institutions, and other market participants.”

Exactly what measures the SEC or other regulators take are up in the air.

“The SEC is very good at this,” said Thomas Gorman, an attorney at Dorsey & Whitney and a former senior counsel at the SEC’s enforcement division. “They’ll get this sorted out.” 

Gorman said the agency has a real-time audit trail of who makes trades and are likely scrutinizing chatrooms and message boards looking for fraudulent comments. If, for example, the SEC sees 10,000 shares of GameStop purchased and then five minutes later sold by the same investor, that would be a major red flag, he said.

Similarly, the agency would target the same or similar comment made in multiple chatrooms. “You see some comment coming out four or five times, you’re going to take a hard look at that,” Gorman said, adding that, despite the heavy movement on Robinhood and retail investment platforms, nobody really knows yet who is really behind all of the big trades. “This may not be the little guy.”

States also could get in on enforcement, though with a situation this large national regulators likely would run point. Massachusetts reportedly is already investigating the heavy trade volume, and other states are watching the situation unfold.

Joseph Rotunda, who heads the enforcement division at the Texas State Securities Board, said that “we are absolutely aware of the situation” but declined to comment on what actions the regulator was contemplating. 

In the meantime, much of the work to curb the turmoil is being done by brokers and platforms.

“Brokers can put curbs on trading in certain stocks to protect the integrity of the market,” Pagano said. “They can also raise margin requirements, which makes it harder for buyers to leverage their equity purchases, thus tamping down some of the buying power of retail traders.”

Retail brokerage platforms have already taken matters into their own, virtual hands. Around mid-morning on Thursday, Robinhood, a retail investor platform where most of the trading had taken place and which has prided itself on “democratizing finance,” announced it was restricting transactions in GameStop and AMC Entertainment shares, another focus of recently massive buy activity.

In a statement, the platform noted that only position closing would be allowed for the shares, and it raise the margin requirements for those and other securities. It later said it would allow limited buying of certain restricted securities on Friday but said it would “continue to monitor the situation.”

Interactive Brokers placed GameStop option began requiring 100% margin for long positions on GameStop shares and 300% margin for short positions on the stock. It also restricted positions on AMC and several other heavily traded stocks.

“We do not believe this situation will subside until the exchanges and regulators half or put certain symbols into liquidation only,” the platform said. “We will continue to monitor market conditions and may add or remove symbols as may be warranted.”

The moves have wrought a potential wave of litigation from investors against who feel Robinhood cheated them out of the opportunity to cash in on the GameStop craze. Derek Smith Law represents investors in two such federal class actions on Thursday, one in Manhattan and another in New Jersey.

A few lawmakers from both political aisles also have called out the trading platforms for unfairly blocking “little guy” investors while allowing hedge funds to recoup some of their losses and Wall Street indices to calm down.

Both Republican Senator Ted Cruz and Democratic Congresswoman Alexandria Ocasio-Cortez said they will look into investigating the matter via congressional hearings. 

David Portnoy, who founded Barstool Sports and has been extremely bullish on GameStop, said the bipartisan support among typically bitter political enemies shows that a hammer is about to fall. 

“PRISON TIME,” he tweeted. “Dems and Republicans haven’t agreed on 1 issue till this. That’s how blatant, illegal, unfathomable events are.”

He added: “Fines aren’t enough. Prison or bust.”

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