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Regulation and Compliance > Federal Regulation > SEC

‘Crowdsourced Lulz’ Are Probably Not Securities Fraud

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SEC headquarters in Washington SEC headquarters in Washington. (Photo: Diego Radzinschi/ALM)

The calls for regulatory action to address the GameStop stock trading frenzy have been as vague as they have been vocal.

If it turns out that the stock price and volume volatility was nothing more than what has been described as “crowdsourced lulz,” the Securities and Exchange Commission doesn’t have tools to address the issue in the absence of material misrepresentations or deceptive conduct.

And in the absence of deception, the SEC would be justified in bringing no GameStop mania enforcement actions.

What appears to have happened over the last couple of weeks is an accelerating number of long purchases by members of the Reddit group WallStreetBets, which has caused GameStop’s stock price to swing wildly in a sharp upward trajectory at enormous volumes.

The price surge has cost money for holders of short positions, which may have been the intent of some of the WallStreetBets purchasers. More recently, some online brokerages have restricted their members’ ability to trade the stock, and this, among other factors, has tamed the GameStop stock price increases a bit.

The SEC’s go-to tool here will be the antifraud provisions of the federal securities laws, prohibiting material, false statements made with fraudulent intent.

Three tactics that would be low-hanging fruit for the SEC would be: false material statements about GameStop, false material statements about a trader’s own intention to buy GameStop shares, and transactions that give the materially false impression of market demand for GameStop shares.

‘PennyStock Pumper’ Case

So, for example, last year when an individual investor in a small biotechnology company anonymously posted messages on Investors Hub using the name PennyStock Alert — let’s call him the PennyStock pumper — falsely and repeatedly claiming, among other things, that the company had received FDA approval for a COVID-19 test (and then selling his shares after the stock price rose), the SEC had no problem bringing a so-called “pump and dump” fraud case.

But to allege fraud, the SEC had to conclude that the shareholder knew or was reckless in not knowing that the FDA approval statements were false, and that such statements were material to the market.

If the SEC identifies someone who made false statements about GameStop knowing or reckless in not knowing that those statements were false, and if the SEC can prove those false statements were material because, for example, the statements caused the GameStop stock price to move, then bringing a pump and dump case would be a layup for the SEC.

In the PennyStock pumper case, the SEC also alleged that the shareholder “posted numerous messages on Investors Hub touting his purchases, or intent to purchase” the biotech company’s stock “in an effort to entice other investors to do the same. However, unbeknownst to other investors, [the PennyStock pumper] quietly sold the stock when its share price increased.”

During the week when the PennyStock pumper was encouraging others to buy, he executed only one purchase order for 5,000 shares but executed 90 transactions selling over 2.5 million shares. In the SEC’s view, the PennyStock pumper’s failure to disclose his plan to sell shares “at the same time he was recommending buying it to others” constituted fraud.

If the SEC identifies someone who said they purchased or intended to purchase GameStop shares in an attempt to encourage others to do so, while secretly and simultaneously dumping shares, the SEC would probably bring an enforcement action.

The PennyStock pumper also allegedly engaged in “spoofing,” placing large orders for the company’s stock and then canceling them before they were filled.

The PennyStock pumper didn’t do himself any favors by posting messages on Investors Hub like “Oh look!! A 2 million share Bid!!” when he placed and canceled such trades. The SEC found such spoofing to be fraudulent.

Market Manipulation

Spoofing is one type of deceptive market manipulation that the SEC frequently brings enforcement actions to stop.

And the phrase “market manipulation” has been used frequently in connection with GameStop to suggest the need for SEC action. But “market manipulation” involving spoofing and other deceptive trading techniques is typically intended to “create the false or misleading appearance of active trading” in a security.

In the absence of such deception, the SEC must prove that a trader effected “alone or with 1 more other persons, a series of transactions … creating the actual or apparent active trading in such security, or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.”

On its face, the GameStop mania appears to be the product of many, dispersed, individual, amateur, retail investors buying a stock disfavored by other market participants with the hope and intent of driving the price of the stock up.

Typical Reddit posts are along the lines of “GME IS THE HOLY GRAIL” or “WE ARE STILL GOING TO THE MOON . . . ITS NOT TOO LATE TO BUY.”

Courts have been reluctant to impose liability for such open market purchases unless there is no legitimate reason for the purchases and the purchases would not have occurred in the absence of an intent to push up prices.

It’s certainly possible the SEC will identify some WallStreetBetters who purchased GameStop shares with the sole specific intent that the purchases themselves would induce others to do the same, but if it turns out that the purchases were made for profit and amusement, the SEC will have a tough row to hoe and may end up “chilling” legitimate market activity.

Capitalist lulz is a weak foundation for an enforcement action.