Will the SEC expand the definition of a pump-and-dump?

The recent GameStop/Robinhood stock trading saga has proved resistant to easy analysis or quick conclusions, both dividing and uniting opinion in unexpected ways. After all, how many things do Ted Cruz and Alexandria Ocasio-Cortez agree on? Yet both here called for a congressional inquiry into those events -- and that inquiry itself proved fascinating, but with few obvious takeaways. One thing that does appear clear is that customer claims against Robinhood for its temporarily halting the trading in GameStop stock appear to face an uphill battle.

First, a brief background on how we got here. GameStop is a longtime brick-and-mortar retailer of videogame products. Many have seen its fate as somewhat analogous to that of Blockbuster, as it peddles physical products in a world that is rendering those products obsolete -- most videogames are now simply downloaded. The company does, however, have its fans. And some of those fans became aware that certain investors, including hedge funds, were shorting its stock -- i.e., betting its share price would decline. This angered those people, and some of them began discussing the issue on the online discussion site Reddit, specifically its "WallStreetBets" investment forum. Many of the participants on the forum then began purchasing the thinly traded stock, which had the effect, at first gradually, and then dramatically, of driving up its share price -- it rose an astounding 1,500% in just two weeks, despite the company's business fundamentals remaining unchanged. This surge in the stock price had the effect of putting the investors who had shorted the stock in a classic "short squeeze": They had to buy shares to close out their short positions, but the cost to do so had risen dramatically. One hedge fund, Melvin Capital, incurred such huge losses that it required an injection of $2.75 billion from hedge fund titans Citadel and Point72 to prevent its collapse.

These events led to two competing narratives. The first posited that what had occurred was a laudable example of many "little guys" banding together to hurt the much-reviled hedge fund short seller baddies, and in process reaping vast profits for themselves. The other narrative claimed that what was really occurring was a digital-age version of the classic pump-and-dump: a group of people agreeing to buy up a thinly traded stock of little value and then tout it to cause its share price to rise -- only to dump their shares at the top of the market, after which the stock collapses with the suckers left holding the bag.

To complicate matters further, many of the Redditors trading the stock were doing so through online trading platform Robinhood, which allows its customers to trade commission free. It is able to provide this cost-free platform by selling its "order flow" -- compensation a broker-dealer receives for sending the trades to a third-party market maker, who is willing to pay for this order flow to allow it to make a market (match trades) more efficiently. But when GameStop's shares started going "to the moon," Robinhood ran into a problem of its own: Its clearing broker demanded billions in collateral that Robinhood did not have to allow it to ensure that its trades settled. This caused Robinhood to have to halt trading in GameStop on its platform -- which locked its customers who wanted to trade out of potential profits or mitigation of potential losses. Some saw this as a nefarious example of Wall Street protecting its own at the expense of the little guy.

All of this led to a congressional hearing on Feb. 22. It generally exhibited the surfeit of heat and paucity of light that make such hearings infamous -- and made for strange political bedfellows. At the end of the day, there were few clear takeaways from the hearing. It appeared that there was at least some support for both of the competing narratives of the trading in GameStop. It also became fairly clear that despite claims that Citadel -- who had bailed out Melvin Capital but whose affiliate was one of the market makers paying Robinhood for order flow -- was not the reason why Robinhood halted trading in GameStop. It was, as noted, because of clearing brokers' normal-course requests for collateral -- it was simple the volume of trading that made the amount of collateral required extraordinary.

Regarding the trading in GameStop stock itself, one thing that is relatively clear, though, is that the Securities and Exchange Commission will need to consider new rules and, certainly, investigate the trading in GameStop. The agency's raison d'être is to protect investors, particularly unsophisticated ones. For many of the folks on Reddit who purchased GameStop shares, it was likely their first purchase of a security. And as much fun as it may have seemed when some of them took huge paper (or even actual) profits at the expense of the hedge fund short sellers, it was entirely less so when the company's stock price (predictably) collapsed, causing many of them to suffer huge losses (and, paradoxically, some of the counter-profits on those losses were reaped by ... wait for it ... yet other hedge funds that had entered the fray and started to go long on GameStop, only to flip the shares at the height).

Although the behavior on the Reddit board does not quite fit into the classic definition of a long-barred pump-and-dump -- because there was a lack of clear agreement amongst its participants to intentionally manipulate the market -- its operation and effect were nearly identical. Certainly the SEC should investigate whether some subgroup of folks posting on Reddit had in fact conspired to drive up the stock's price with the intention of then selling it -- if that could be proved though an examination of those peoples' Reddit posts and emails and texts with one another, it would pretty clearly be a violation of existing rules barring pump and dumps and subject those persons to civil liability to the SEC or, even, criminal prosecution by the Department of Justice.

The much more difficult question is whether the SEC needs to create new rules to expand the definition of a pump-and-dump or otherwise prevent this situation -- which was to the substantial detriment of many unsophisticated investor -- from occurring again. How this could be accomplished, or whether it is even possible, is hard to say. But one should expect and look forward to an SEC report in the future on this issue and what new rules, if any, are proposed.

As for claims against Robinhood by its customers who were temporarily locked out of trading GameStop stock, at least based on the evidence that came out of the congressional hearing, it does appear relatively clear that the halt in trading was in fact driven by legitimate collateral requirements it could not immediately meet without an infusion of capital of its own, and not some nefarious conspiracy between it and Citadel. At least assuming no material new evidence comes to light, that would appear to make the recently filed investor claims against Robinhood to be a heavy lift indeed. 