After a whirlwind week in the markets that saw shares in ailing video game shop GameStop rise by over 12,500 per cent, investment platform Robinhood has been hit with a class action lawsuit in the US for what the claimants call market manipulation.

When big swings in prices and an unprecedented volume of trading saw the platform take the controversial decision to restrict people from buying more shares in GameStop, scores of amateur investments cried foul, insisting that their interests were thwarted to prevent the large hedge funds who had bet against the video game store from further losses.

Below, we examine the legal position of hedge funds, intermediaries and the social media community who made history.

Naked shorts and the case of GameStop

Short selling is by no means new. In fact, to bet against a failing business is a common tactic employed by sophisticated hedge funds globally. In this case, the target was GameStop – a business who’s high-street-first model meant it was already struggling prior to the pandemic. For short sellers, it was a no-brainer: GameStop was a prime candidate, and betting against them was just another day, another dollar on the stock market.

It appears that some of these hedge funds may have even been running what is known as “naked shorts”, a now-illegal practice of selling short shares that have not been determined to exist. Ordinarily, traders must borrow a stock or at least determine that it can be borrowed so as to back up their short position. After the financial crash of 2008, the SEC tightened rules in the US to prevent naked shorting and added the “uptick rule” to stop short sellers from piling on to a falling stock.

Nevertheless, the hedge funds made what felt like a safe decision to short sell the stock of a company whose outdated model was bound to fail, confident that they could buy them back cheaper down the track. Despite the practice being illegal, one hedge fund in particular was so headstrong that it sold a boatload of naked shorts on GameStop – it was certainly a risk, but not one they considered a bad one going purely on fundamentals.

What they didn’t realise was that their “fool-proof” strategy was on the cusp of collapse and they would soon fall victim to the most unusual situation. For the first time in the modern history of the stock market, David would fight back against Goliath.

David, in this case, came in the form of r/WallStreetBets, a community on Reddit eager to prove a point to “the bad guys”. The catalyst was a mass, ad-hoc effort from the group to buy the stocks of the most heavily shorted companies on brokerage platforms such as Robinhood and Trading212 in the hope of triggering a short squeeze and forcing “Goliath” to scramble and cover their positions. To their surprise, the strategy was a rip-roaring success in the case of GameStop: Redditors took GME stock and its short-squeeze peers to the moon.

Did trading platforms act unlawfully?

In the heat of the moment, things took an unexpected turn for r/WallStreetBets when Robinhood took the decision to prevent more purchases of GameStop shares as they looked to grow further. Similarly, retail investors trying to buy the stock through UK platform Trading212 received a message on Thursday saying:

“In the interest of mitigating risks for our clients, we have temporarily placed GameStop in reduce-only mode as highly unusual volumes have led to an unprecedented market environment.”

Trading212 announced an update on Friday saying trading was enabled again, while Robinhood said limited buys would be permitted. Inevitably, the restrictions were met with outrage – and not just in the reddit community. Beyond the posters on r/WallStreetBets and the retail investors who had thrown their money behind GameStop, voices across the political spectrum have spoken up and made calls for harsh legal action. New York Rep. Alexandria Ocasio-Cortez is calling for a deeper investigation into the Robinhood bans, while Texas Senator Ted Cruz is doing the same.

But did Robinhood and other platforms do anything illegal here?

Arguably, the obligations that Robinhood and others like Trading 212 have to their clients and the market allow them to take the action they did. Presumably, the brokerage followed the terms spelled out clearly in their customer agreements. Further, SEC regulations require Robinhood to have a certain amount of capital or they’ll be shut down – there’s no doubt that the SEC have watched closely to ensure brokerage companies are in compliance with the strict governance rules that apply to them.

On that note, the CEO of Robinhood Vladimir Tenev defended their position, explaining that the clearing house had demanded $3 billion in security at 3am the morning before the company stopped GameStop trades. In a statement released last week, he made his company’s obligation to complying with their financial requirement abundantly clear, and stood by his defence that Robinhood has always stood by the individual investor.

‘We have to put up money to the NSCC based on some factors including things like the volatility of the trading activity into certain securities,’ he explained during a Clubhouse virtual event on Sunday night.

‘And this is the equities business, so it’s based on stock trading and not options trading or anything else. So, they give us a file with the deposit and the request was around $3 billion, which is, you know, about an order of magnitude more than what it typically is.’

Across the pond, UK traders are considering taking legal action against Trading212, who restricted trades in a similar move. According to their terms and conditions, Trading212 state that they do not manage their clients’ accounts:

As a reliable and regulated by the FCA broker we do not offer any trading or financial advice, nor do we manage our clients’ accounts. What and how you decide to trade or invest will be your responsibility.

Did r/WallStreetBets act unlawfully?

While much of the discussion has centred around the lawfulness of the restrictions placed on trades by Robinhood and similar platforms, there has been far less focus on the actions of the Reddit community themselves. The question is, was the GameStop situation just a group of people making their opinions known, or was it a concerted effort to manipulate the value of the stock? Joshua White, assistant professor of finance at Vanderbilt University who has authored market analysis for the Securities and Exchange Commission, said the situation resembles a “classic pump-and-dump scheme”.

To those unfamiliar with the term, a pump and dump scheme is an illegal trading technique whereby investors attempt to boost the price of a stock through recommendations based on false or misleading statements. Those boosting the price will already have an established position in the company’s stock – thus, by generating market hype, they can sell their positions for a higher share price.

As of now, there’s no real concrete ruling that GameStop is a case of a pump and dump scheme. When piling behind the stocks of a failing video game shop, it’s abundantly clear that the primary intention of r/WallStreetBets was to thwart hedge funds (and make money in the process.) Whether or not the Reddit community’s purchasing of GameStop shares will meet a legal definition of artificial market manipulation is unclear yet – what we do know is that certain hedge funds have suffered serious damage in the process.

It’s worth acknowledging that, while hedge funds like Melvin Capital who got burned on their shorts of GameStop entered dangerous territory, Melvin generally manage money for charitable organisations and regular people who rely on these funds for retirement. As such, it isn’t just the fund managers who lose when markets are manipulated. If anything, the headline-dominating story serves to reinforce the need for markets to accurately reflect the true value of stocks and for markets to function in a legal and healthy way.

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