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When Davids on Social Media Topple the Goliath of Wall Street
January 28, 2021
Social media started out as a way to connect with old friends and distant relatives. Not anymore. Now, social media is being weaponized by everyday people to topple the giants of Wall Street. Recently, posters on Reddit and Discord saw an opportunity and pounced on it. They saw that major hedge funds had taken significant short positions against Game Stop, the retailer that sells video games and pop culture related merchandise in your local strip mall. With the recent advent of streaming games, Game Stop has seen a steady decline in sales that result in its need to close stores. Capitalizing on this trend, hedge funds took advantage of the situation and shorted Game Stop's stock, putting further downward pressure on the stock. However, Game Stop's cost cutting and increased sales as the result of people being forced to stay home due to COVID-19 resulted in Game Stop seeing positive movement out of the red. Therefore, these large short positions did not correspond with the health of the company. Almost as a joke, a small group of retail investors saw an opportunity to hit back at large hedge funds who, up until now, have been the market makers on Wall Street.
To accomplish this, individual retail investors began to coordinate on social media platforms like Reddit and Discord and utilized the new online trading platform, Robinhood (an irony I am sure was not lost on anyone), and they began a movement to buy Game Stop stock. The hedge funds, who were contractually obligated to buy, along with this concerted effort by individual retail investors to push up the price of the stock resulted in Game Stop's stock rising more than 10,000 percent. Elon Musk was vocal in his support of this merry band of investors after having Tesla's stock attacked by short sellers. The result of this concerted effort by an army of individual investors was that when these hedge funds' future options came due, instead of paying $3.33 a share as anticipated, the hedge funds now, by contract, were required to purchase the stock at over $300 a share. This was catastrophic to the hedge funds holding these short positions, with one hedge fund now being in total collapse and likely going into bankruptcy after having lost more than $14 billion on its short positions on Game Stop in only the last few days. All told, these grassroots challenges to the powers on Wall Street have cost short sellers $70.8 billion since the beginning of the year.
But, are the actions by this disseminated band of rogue investors illegal as alleged by Wall Street and the financial media? The short answer is no. Contrary to allegations by the financial media, the actions of this group of investors do not amount to an illegal pump-and-dump scheme. A pump-and-dump scheme is traditionally when a fly-by-night brokerage creates a market in a stock out of whole cloth through the sales of a stock it owns to unwitting and unsophisticated investors (e.g., the Wolf of Wall Street). When the brokerage has sold its shares, it exits the market, thereby causing the market to collapse because the market was only an illusion supported by the sales of the stock held by the brokerage. In this instance, the market is real and not illusory because the holders of the future options are contractually obligated to buy when their options come due. Short sellers bet on the fact that between the time they buy the future option and the time it comes due, the purchase price of the stock has fallen to allow them to make a profit on the price differential. Here, the individual investors have caused the price of the stock to astronomically rise, forcing the short sellers to buy the stocks at significantly higher prices and incur tremendous losses. As a result of this volatility in the market, the SEC has pledged to look into these events and evaluate if any wrongdoing has occurred. While what these individual traders have done is currently legal, the SEC cannot tolerate such market volatility, and it will likely try to make an example of those who profited off this scheme in an attempt to stop the bleeding. One way the SEC and DOJ could go after these vigilante investors is to say that they engaged in illegal market manipulation in violation of Section 9 of the Securities Exchange Act of 1934. While actions by the SEC and DOJ may not result in convictions, it will work to sooth the tattered nerves of Wall Street; it may end the volatility in the market and stop the insanity by scaring off these rogue investors.
Emboldened by the success of their scheme, rogue investors are targeting other companies to champion, including AMC and Blackberry. These are both companies that have significant short positions against them. In order to stop further discussions on their platforms about how to financially attack Wall Street, Reddit and Discord have shut down Reddit groups and Discord servers, like WallStreetBets. In an attempt to stop the bleeding, trading platforms like Robinhood and TD Ameritrade have put trading limitations, if not entire trading prohibitions, in place for Game Stop stock and other likely targets. However, there is no reason to stop the trading on these stocks, which remain listed on their respective stock exchanges, other than to stem the losses suffered by Wall Street. This action by Robinhood to halt trading on Game Stop stock on its platform appears to be in violation of Robinhood's terms of service. In response, users of the Robinhood platform immediately filed a class action lawsuit against Robinhood for breach of contract, breach of fiduciary duty, breach of the duty of good faith and fair dealings, and negligence in the Southern District of New York. This is only the beginning, and with Wall Street's nose having now been bloodied, a lot more litigation is likely to come.
This use of social media in this way to influence investing has never been seen before. What it has done is shown that the playing field between those on the ground and those in the gilded towers of Wall Street can be leveled. Unlike King David, who ended a war by slaying Goliath, the Davids on social media have only started one. Time will only tell whether they are able to topple Wall Street once and for all.
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Consumer Finance Alexander L. Turner