Here's why lawyers and former regulators say the SEC's hands are tied despite calls to clampdown on GameStop trading fiasco

  • Wall Street is scrambling as day traders on Reddit sent GameStop’s shares skyrocketing.
  • Institutional investors, state regulators, and lawmakers are calling for the Securities and Exchange Commission to take action.
  • Securities lawyers and former regulators, however, think it’s unlikely that the SEC can implement major changes.
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Calls for federal regulators to take action on the ongoing GameStop saga are mounting.

Wall Street Bets, a Reddit forum of now more than 5 million day traders, collectively drove up the gaming retail company’s stocks. Shares were priced at below $5 in late 2020 skyrocketed over the last three weeks, hitting $450 per share on Thursday morning. The moves sent some prominent hedge funds that had shorted the stock scrambling and incurring huge losses.

Then stock prices plunged on Thursday as much as 60% after Robinhood and other platforms restricted trading of GameStop’s shares and other popular securities like AMC, sparking critique from figures like Rep. Alexandria Ocasio-Cortez of New York.

Read more: Robinhood user launches class-action suit against the trading app hours after it blocked purchases of GameStop

Despite the uproar from hedge funds and scrutiny from lawmakers on Capitol Hill, three lawyers, two of which are former regulators, say that the Securities and Exchange Commission (SEC) is unlikely to make any sweeping changes.

Regulators are being called on to investigate market manipulation

The SEC will likely step in to investigate the GameStop boom and determine if anyone did manipulate the market, using its market surveillance tools to figure out who’s trading, which traders had significant gains, who they talked to, and what they said, said Trace Schmeltz, a partner who heads Barnes & Thornburg’s financial and regulatory litigation group who’s worked on cases involving the SEC for around 20 years.

Gary Gensler, President Biden’s pick for SEC chairman and widely regarded as a hard-knuckle regulator who’s expected to bring about a more transparent market, probably won’t be confirmed for weeks or months.

And, given the size and scope of the situation, Schmeltz said it’s likely to see the Federal Bureau of Investigations being roped in as well, giving investigators search warrant and wiretap abilities.

Regulators would ultimately need to prove that the traders deceived or misled the market with the express aim of manipulating investors to buy or sell securities, which is illegal under US law. 

The SEC will probably investigate the matter but is unlikely to find proof of illegal activity

Legal experts, however, believe that it’s improbable that investigators will be able to prove manipulation of the market.

While the Wall Street Bets traders might be accused of manipulation in the colloquial sense, manipulation is a strictly defined term when it comes to the law. Rigged trades, such as “pump and dump” schemes where investors conspire to trade together to push the price up, are examples of this.

Aitan Goelman, a partner at Zuckerman Spaeder who served in the Commodity Futures Trading Commission, said that the four-part test used by the CFTC to prove manipulation is notoriously tough to prove — so much so that he doesn’t recall if the CFTC has ever succeeded in doing so.

Even if some Redditors have come out and said the GameStop rally is an act of revenge against Wall Street, regulators wouldn’t be able to hold them liable for wrongdoing.

“The law does not penalize pure intent, no matter how nefarious as it may seem, unless some type of fraud or manipulative device is used,” said Andrew Calamari, a partner at Finn Dixon & Herling and a former director of the SEC’s New York regional office.

The steps the SEC can take are limited and could lead to unintended consequences

The options available to the SEC absent proof of deception or manipulation are few, and unlikely to lead to viable, sweeping changes, said the securities experts.

State regulators have called on the New York Stock Exchange to suspend GameStop for a cooling-off period of 30 days, during which the “market euphoria” driven by social media might be quelled, said Schmeltz.

Experts are skeptical of just how effective a cooling-off period would be, however.

“All these breaks are doing is giving these traders more fuel and the chance to hype things up even more,” said Goelman.

Another course of action would be for the SEC to clamp down on options trading, which is a trading tool favored by the Reddit crowd. Call options give holders a right to buy a stock at an agreed price within a certain date, essentially allowing investor to bet that the stock will rise, while puts give the right to sell at a certain price.

Read more:How hedge funds are tracking Reddit posts to protect their portfolios after the Wall Street Bets crowd helped tank Melvin Capital’s short positions

Schmeltz explained that placing artificial limits around market liquidity tools like options could create different market distortions. By putting a limit on the number of call options that trade, for instance, you would drive up the price of the calls, which might be problematic for other stocks.

Calamari suggested that the only action the SEC can take in a situation like this is to educate investors better. (The commission’s office of investor education Tweeted a link to an article on the risks of day trading on Thursday.)

 

“You have a bubble here, and it just doesn’t seem to me that there’s a lot the SEC can do about that other than warn people that it’s a bubble,” Calamari said.

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