What Happened With GameStop and Why Securities Regulators Are Watching

You may have heard that GameStop, the once-ubiquitous strip mall video game store, had a good week for its stock price: A really good week.

The price rose nearly 700% over the span of a few days, earning billions for a few and costing hedge fund Melvin Capital an extreme loss estimated to also be in the billions. Not because of any earnings report, merger, or other event that would influence share price, but because some Reddit users decided en masse to buy the stock price of the company in a move called a short squeeze.

Defining a Short Sell and a Short Squeeze

To short sell, you first borrow shares from a broker with the promise to return them by a set date. You then immediately sell those borrowed shares at the current market price. If the price shares drop by the time you agreed to return the shares, you buy the shares at the new lower price and get to pocket the difference. If the price goes up, though, you lose money – potentially a lot. Because there is no upward limit on a stock price, in theory a short seller can suffer infinite losses.

A short squeeze, on the other hand, occurs when investors purposefully inflate the price of the stock in response to an ongoing short sell. This causes the short seller to close out early to avoid further losses, which further drives up the stock price.

If you're thinking these schemes sound more like poker than investing, you're not wrong. Both are risky, but they can lead to remarkable gains and losses, as exhibited by GameStop's shares this week.

It Is (Mostly) Legal

Despite the buzz surrounding GameStop and AMC Theatres, another company undergoing extensive short trading, this is not the first time this has happened. Similar buying frenzies occurred in the 2000s with the dot-com bubble, and in 2018, a Canadian pot company, Tilray, experienced a similar artificial inflation of its stock price.

Short selling and short squeezing are not illegal. Nonetheless, the Securities and Exchange Commission, and state securities regulators, are watching these events closely. Here's why.

False or Misleading Information

A number of retail brokers now exist that are targeted toward armchair investors. Robinhood is a popular app anyone can download, for instance. On Reddit, there are dedicated channels on investments. This past week, thousands of messages promoted GameStop, urging people to buy and to keep what shares they have.

Again, nothing in the above is necessarily illegal. However, the SEC is likely to investigate whether any of the investors who were holding the stock long-term or who were trying to short squeeze the stock were manipulating investors.

Market manipulation occurs when there is intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities. For example, Section 17(b) of the Securities Act prohibits “touting," or being paid to promote a stock without revealing that you are being paid to do so. It also generally prohibits deceit, misrepresentations, and other fraud in the sale of securities. A common example is known as a "pump and dump" scheme, where you get buy-in from a large number of investors to temporarily inflate the stock price and sell while it is briefly high.

What You Need to Know

What does this mean? An armchair investor who read something on Reddit and subsequently purchased shares of GameStop on Robinhood is unlikely to get into any legal trouble. If, however, you intentionally interfered with the market price by spreading false or misleading claims on Reddit, it is possible you could be investigated.

For now, Robinhood stopped, and then resumed allowing its users to buy Gamestop shares in limited quantities, along with other suspiciously hot shares like AMC. The New York Stock Exchange is similarly looking into putting a hold on Gamestop for 30 days.

As a result of this week's events, regulators and lawmakers may look at ways to curb this kind of social-media induced buying frenzy. While it can feel good for armchair investors to get short-term gains while a hedge fund loses billions, it can lower the integrity of the market and put individual investors at risk. With retail trading and social media, the chances of something similar happening again are relatively good. Good enough, at least, that some people will bet on it again.

Related Resources:

• Securities Fraud (FindLaw's Learn About the Law)
• What Happens Next for Social Media? (FindLaw's Law and Daily Life)