GAMESTOP SAGA – WHO BEARS SHORT SHORTS?

The proliferation across social media of speculative, bullish sentiment among a bloc of retail investors to the extent seen recently with GameStop was unprecedented. The GameStop saga marks the first clear manifestation of the collective buying-power of a new crop of retail investors and their ability to potentially distort financial markets. In many ways, it presents a novel phenomenon which could happen again. But what are the potential implications of this "democratisation" of share trading?

Retail, social-media driven investment could be one of the next big regulatory battlegrounds over the coming years (and, in turn, fertile ground for litigation), which could have profound implications for the financial services industry. Regulation will once again need to play catch-up with technological innovations which have shaped the way retail investors participate in the market, aided by social media's apparent ability to influence consumer behaviour and attitudes to risk.  

In early January 2021 GameStop, a beleaguered bricks and mortar US gaming retailer, had a share price below $20. It was heavily shorted by hedge funds, with short interests exceeding 100% of outstanding shares. Just a few weeks later, on 28 January 2021, following a Reddit-fuelled short squeeze of these hedge funds' positions, GameStop's share price had surged to an intra-day high of $483. It later closed that day below $200, after a number of trading platforms restricted trading of GameStop, citing SEC capital requirements that require brokerage firms to hold enough capital relative to the volume of outstanding trades as collateral for clearing houses.  Its share price eventually slumped to under $45 a share by 23 February. Remarkably, though, in a pattern of volatility again belying the economic reality, GameStop's share price recently soared to heights approaching those seen at the end of January, reaching an intra-day high of around $330 on 10 March before quickly receding again.

The price surge was uniquely driven by retail investors, led by a number of prominent Reddit users who pitched the buying frenzy as a "David vs Goliath" battle to upset the established equilibrium of wealth and power on Wall Street.  Retail investors piled into GameStop, in many cases leveraging their trades through access to cheap credit or purchasing call options at a lower upfront cost.  As the price soared, retail investors urged each other to hold their nerve and cling onto their shares with "diamond hands", heaping pressure onto the short positions taken by the hedge funds.

Inevitably, there have been both winners and losers – some retail investors cashed out at the top of the market and will have made a hefty profit, others who missed the boat have been left saddled with loans they cannot afford to repay.  And while some hedge funds will undoubtedly have received a bloody nose – and in some cases, significant losses to exit their positions – it hasn't yet led to the collapse of the hedge fund market that some Reddit users had hoped for.

As GameStop represents what is essentially a novel phenomenon, the reaction of US regulators offers a useful gauge as to how the unique factual and legal issues it throws up could be addressed in future. In a statement released on 29 January 2021, the Securities Exchange Commission (the SEC) was quick to say that it would step in to "protect retail investors when the facts demonstrate abusive or manipulative trading activity" and would be "closely review[ing] actions taken by regulated entities". On 30 January 2021, the SEC then issued a stark, general warning to retail investors on the risks of "investing in bubbles or manias" and warned of "the potential for market manipulation on online platforms". 

On 18 February 2021, the US House of Representatives Committee on Financial Services held a hearing in which key participants involved in the GameStop saga gave evidence before US Congress. A memorandum providing notice of the hearing pointed to the possibility of regulatory action and legislative reform on the horizon, questioning the efficacy of "existing rules governing short sales and related disclosures" and "anti-market manipulation laws" in protecting retail investors. It went on to say that, at the centre of this discussion, was the underlying concern that "technology and social media have outpaced regulation in a manner that leaves investors and the markets exposed to unnecessary risks." Chairwoman of the Committee on Financial Services, Maxine Waters, has confirmed another hearing on "SEC & regulatory response / solutions" (as yet unscheduled). This promises to reveal how realistic the prospect of wholesale regulatory and legislative reform is in the US.

Despite UK retail investors also being caught up in the GameStop saga, the FCA has not yet publicly announced that it will conduct its own probe. Whether the FCA takes any investigatory or enforcement action remains to be seen; in a statement issued on 29 January 2021, the FCA promised "appropriate action wherever [it sees] evidence of firms or individuals causing harm to consumers or markets”. This could come in the form of the FCA assisting the SEC (if requested) under its general duty to co-operate with overseas regulators (section 354A FSMA 2000). The FCA also cautioned UK investors against "trading both US and UK stocks […] in highly volatile market conditions", particularly since losses suffered "are unlikely to be covered by the Financial Services Compensation Scheme".

Market manipulation – just hype, or something more?

In light of the events surrounding GameStop, the FCA reminded firms and individuals to "ensure they are familiar with, and abiding by, all regulations including the market abuse and short-selling regimes in the jurisdiction they are trading in". Under the UK Market Abuse Regulations (UK MAR), the FCA only has powers in relation to financial instruments admitted to trading on a UK or EU regulated market (Article 2(1) UK MAR); these powers would not extend to GameStop shares, which are listed on the New York Stock Exchange.

That said, the FCA will still no doubt be considering whether the sort of phenomenon seen with GameStop could be repeated in the context of UK or EU-traded securities. Of interest to the FCA will be a 23 February 2021 statement on GameStop issued by Stephen Maijoor, the Chair of the European Securities and Markets Authority (ESMA), who speculated that "coordinated strategies to buy and sell at certain conditions and at a certain point in time", as well as "posting false or misleading information about an issuer or a financial instrument on social media", could constitute market manipulation. Clearly, though, some distinction would need to be drawn between much of the widespread online hype and encouragement observed in GameStop and sending out "false or misleading" signals or information to the market for the purposes of Article 12 UK MAR.

Trading platforms – market disruptors or market distorters?

The same statement from the Chair of ESMA calls for an investigation into "the role of online brokers’ business models", amid concerns that they may "incentivise the adoption of risky short-term trading strategies by retail investors." One point of concern for regulators could be the ease with which retail investors were able to use trading platforms like Robinhood with little in the way of limits to their potential exposure or warnings against the exorbitant risks at play. The FCA could consider implementing restrictions similar to those it set on the sale to retail investors of contracts-for-difference (CFDs) in July 2019. These set limits on how much retail investors could stand to lose, imposing various affordability criteria and ensuring that they were not going into a trade with too much leverage or too little margin upfront. An FCA-commissioned research report called "Understanding self-directed investors", published in March 2021, suggests that GameStop has only brought consumer harm concerns into sharper focus for the FCA.

Social media and online financial harms – FCA already ahead of the game?

Shortly after the GameStop saga, according to a BBC report, the FCA warned retail investors of the "risks with taking unregulated investment advice" increasingly being found online. The FCA's concern is that trading tips shared in posts and videos online (often anonymously) could amount to what is effectively financial advice, but without bearing the usual disclaimers on the risks inherent in financial markets and the associate regulatory protections afforded to retail investors. The article also cites the FCA's commitment to "engage with social media platforms to have pages which breach [its] regulations taken down" and its pressuring of the government to include fraud and "financial harms" in the upcoming Online Safety Bill 2021. The Bill, if it were to extend to include financial harms as urged by the FCA, could impose a duty of care on social media platforms and online forums that host user-generated content accessible in the UK to monitor and root out offending material online.

The FCA response may depend on how the SEC proceeds and the extent to which its initial probe uncovers any wrongdoing. If it does, there may be political pressure for other regulators such as the FCA to follow suit. Indeed, in a statement on 17 February 2021, ESMA made clear its view that "although market rules and structures are different in the EU [to the US], it cannot be ruled out that similar circumstances may occur in the EU as well.” The same concerns, no doubt, will be shared by the FCA.

At the time of writing, we are not aware of claims that have been filed in the US specifically against hedge funds with short positions in GameStop, whether by retail investors who might allege that their losses in some way flowed from abusive short selling practices, or by their own clients attempting to recoup their losses in contractual breach of mandate or negligence claims. 

But, as early as 27 January 2021, a federal claim was being filed by retail investors as a class action in the US against trading platform Robinhood relating to its decision to impose restrictions on trading of GameStop shares (Brendon Nelson v Robinhood Financial LLC). This claim is reportedly one of dozens of similar claims already filed in the US. On 16 February 2021, a federal class action was also filed against Keith Gill (a.k.a. "Roaring Kitty"), a prominent voice on the WallStreetBets Reddit forum (Christian Iovin v Keith Gill). The claim alleges that Mr Gill used "deceitful and manipulative conduct" through his extensive social media presence to convince potential investors to purchase securities in GameStop, with the intention of artificially inflating its share price which, in turn, would net him significant personal gains. 

We are not aware of any claims that have been filed in the English courts relating to the events surrounding GameStop. That said, there remains a possibility that prospective claimants become galvanised by test cases in the US in the event they are allowed to proceed, or by regulatory investigations uncovering instances of wrongdoing.

Claims by individuals in the UK will face a number of potential hurdles; who to sue and what the cause of action might be are the two most obvious. Are claims against the prominent Reddit users who encouraged the trading frenzy realistic? We can see difficulties with such claims. Claims against trading platforms for restricting trades might look more attractive to disgruntled investors.  Investors might seek to argue that restrictions prevented them from profiting from the rocketing price, or from cashing out before the price started to crash.

However, importantly, trading platforms' standard terms of use often afford them broad discretionary rights to unilaterally restrict trades. In the absence of any bare and unqualified obligation in law for trading platforms always to accept and execute trading instructions, it would appear that these sorts of rights could be enough to defeat claims of the type being brought against Robinhood. A statement made by the FCA on 29 January 2021, defending the decision taken by several trading platforms to restrict trading in GameStop, made clear that "broking firms are not obliged to offer trading facilities to clients" and that during periods of abnormal price volatility, trading platforms "may withdraw their services, in line with customer terms and conditions if, for instance, they consider it necessary or prudent to do so".

The strength of the position of trading platforms may depend on further investigation – particularly into whether (as has been alleged in the US with Robinhood) any conflicts of interest arose with market makers or hedge funds as against Robinhood's customers, or whether it treated certain customers preferentially over others in its decisions to restrict trading in GameStop.

Even if GameStop's immediate impact is largely confined to the US, regulators and the financial services industry in the UK will be paying close attention to how things develop in the US as a benchmark for similar factual and legal issues playing out in the UK. They will also be aware of its potential to happen again, taking the latest episode of GameStop's volatility in March as a timely reminder that this is unlikely to be an isolated event.

Given the political heat calling for regulators to take decisive action, it is possible that GameStop could mark a regulatory and legislative sea-change. Such changes could address new challenges to established norms in financial markets thrown up by the GameStop saga, caused in part by advances in technology which may have outpaced current regulation. They might also focus on transparency in the market, requiring greater disclosure from hedge funds as to the short positions they hold, changes to the business models of trading platforms to afford greater protection to retail investors, increased scrutiny into the part social media plays in facilitating market distortion, and potentially larger capital requirements for systemically important market participants.