No quick fix for SEC in cracking down on GameStop-like frenzies

GameStop’s shares skyrocketed this week, turbocharged by bullish touts on Reddit and other online forums.

New market dynamics are an issue that the United States Securities and Exchange Commission will have to increasingly deal with because Twitter and online message boards are allowing armchair stock analysts to spread their views like never before [File: Joshua Roberts/Bloomberg]

U.S. regulators are likely to scrutinize the quadrupling of GameStop Corp.’s shares over the past two weeks, a breathtaking buying spree turbocharged by bullish touts about the video game retailer on Reddit and other online forums.

Yet for the Securities and Exchange Commission, fighting online commentary that hypes stocks is an uphill struggle, mainly because it’s hard to prove such posts are part of an illicit scheme to manipulate the market. Rather, successful enforcement cases typically hinge on the SEC showing that investors knowingly spread false information to dupe other traders into buying or selling a stock.

“It’s an enforcement nightmare for the SEC,” said James Cox, a professor at Duke University School of Law who focuses on securities regulation. “The question is: where does the manipulation start and when does trading on your own hunches and publicizing your hunches start?”

As of now, GameStop has been a market success, its main victims being professional speculators like hedge funds who shorted its stock. But the SEC has been sensitive in the past to the risk of mom-and-pop investors getting caught up in buying frenzies that end in steep losses should the market turn.

Getting ahead of that threat poses an early test for Gary Gensler, President Joe Biden’s pick to lead the SEC. The former Commodity Futures Trading Commission chairman is viewed as a tough watchdog and with everything from SPACs to penny stocks booming, responding to bubbles might be a defining theme of his tenure.

While it began on obscure Internet sites, GameStop’s story is now known to everyone on Wall Street. The 37-year-old video game retailer, its brick-and-mortar business model presumed dead amid years of declining profits, has become an obsession of amateur stock jocks in Reddit’s WallStreetBets forum, whose deep value thesis morphed into a craze that is testing the mettle of short sellers. While no regulator has weighed in on the chat-room campaign, its concerted nature sits uneasily next to a stock where 50% swings are now a daily feature.

For the SEC, it’s not fraud when someone contends that a stock is undervalued, even if such arguments are disseminated to millions through social media. What becomes problematic is if investors post specific claims that aren’t opinions, such as asserting that a company is planning to file for bankruptcy. But homing in on such commentary, figuring out who’s behind it and what their motives are can be difficult for government agencies with limited resources like the SEC.

“If you can actually catch people knowingly passing on fraudulent information, then that is clearly illegal,” said James Angel, a finance professor at Georgetown University. “If all they are doing is saying, ‘hey I think this company is a good buy,’ there’s not a lot anybody can do about that.”

SEC spokesman Kevin Callahan declined to comment.

One thing that can’t be said of GameStop’s chat-room boosters is that they’ve been wrong thus far. While people can disagree on whether the stock was ever cheap, the last few days provide strong evidence that GameStop was vulnerable to a short squeeze, with bearish bets totaling more than 100% of its outstanding shares. Another strategy encouraged on Reddit — calling up brokers and insisting they not lend out shares for shorting — is a standard right of clients.

Reddit is also routinely used to drive up penny stocks that, unlike GameStop, have ceased publishing financial results and don’t trade on regulated exchanges. In such instances, the SEC often cracks down not by going after those touting the shares but by suspending trading of the defunct companies or revoking their registrations, which prevents brokers from executing trades.

Such market dynamics are an issue that the SEC will have to increasingly deal with because Twitter and online message boards are allowing armchair stock analysts to spread their views like never before. There’s no question that such opinions are being devoured, in many cases by the army of investors who’ve taken up day trading during the coronavirus pandemic.

The SEC has shown it’s eager to go after frauds involving the hyping of shares, particularly instances of promoters touting securities without disclosing that they are being paid by companies. Among those the agency has accused of misconduct in recent years are actor Steven Seagal and boxer Floyd Mayweather, both of whom recommended initial coin offerings. If the SEC were to find that posters on Reddit were recommending stocks without disclosing compensation, then it could conceivably bring similar cases.

Plus, enforcement isn’t the SEC’s only tool to temper some of the mania that has engulfed markets over the past year. Last June, the SEC stopped Hertz Global Holdings Inc. from selling new shares that the bankrupt car-rental company described as potentially “worthless.” Hertz was seeking to take advantage of an almost tenfold increase in its stock and investors were eager to buy up the shares before the SEC stepped in.

The challenge for the SEC is that Hertz and other companies are quite receptive to demands from their regulator. The same can’t necessarily be said about traders who post commentary on Reddit message boards and Twitter.

Source: Bloomberg