Reddit And GameStop Lessons: Former SEC Enforcement Chief Explains Stock Manipulation And How To Avoid Trouble

As just about everyone knows by now, investors communicating on the Reddit forum WallStreetBets drove up the stock price of GameStop while openly discussing both their tactics and their reasoning. Some of them purchased GameStop shares as part of a strategy expressly intended to squeeze hedge funds that were shorting the stock. Others simply saw the stock as undervalued.

Will they face charges of stock-market manipulation from the SEC, or even criminal charges? What can investors legally say about a company that could move its share price? What trades can they make individually or together without risk of a government crackdown?

To get insights and lessons for all investors, I turned to attorney John Reed Stark. From 1998 through 2009, he was Chief of the Office of Internet Enforcement at the US Securities and Exchange Commission (SEC). His team investigated hundreds, perhaps thousands, of stock-promotion schemes orchestrated via online message boards. He’s currently president of John Reed Stark Consulting LLC, a firm specializing in data-breach responses and digital compliance. He’s also a Senior Lecturing Fellow at Duke Law School.

1. When can the activities of individuals in online forums such as WallStreetBets on Reddit raise legal risks for them?

It’s actually a lot more complex than most people realize. The SEC issued an ominous January 29, 2021, Statement along these lines, containing this nugget about market manipulation, which raised a lot of eyebrows: “[W]e will act to protect retail investors when the facts demonstrate abusive or manipulative trading activity that is prohibited by the federal securities laws. Market participants should be careful to avoid such activity.”

However, the SEC statement is a bit misleading, because the conduct on Reddit is not the typical kind of market manipulation that the SEC usually charges. Historically, SEC manipulation cases have fallen into two categories:

• First, charging that persons created a false sense of volume and interest in a stock using sophisticated techniques such as washed trades, matched trades, and layering or spoofing; or
• Second, spreading false information to drive a stock price up (or down) in the form of a pump-and-dump scheme, such as using social media to publish a bogus press release about positive earnings; a phony rumor of a new treatment that cures AIDS; a fake-news story about an acquisition; or any other scam or masquerade that could somehow jump-start a stock price to go up or go down.

Without some false catalyst or other deception, creating a herd to generate excitement about an investment, and being transparent about your objectives, is not fraud in connection with the purchase or sale of a security.

2. Can investors band together to buy stock or options in a company without it being illegal?

Whether the banding together by Reddit users to buy a stock is illegal is always going to be a matter of intent, that is, an intent to artificially distort the market for a security. Historically, the SEC has required some sort of deception, fraud, false statement, etc. before charging any sort of unlawful activity.

I also can’t help but notice at least one odd irony here: that banding together is not limited to Reddit users. Hedge funds band together too. Many hedge-fund managers freely share investment ideas with one another, through instant messages, emails and private chats. In fact, according to a Wall Street Journal article, some hedge-fund trades stem from what are so-called “idea dinners,” where hedge-fund managers discuss stocks, markets, and economic trends.

Just like Reddit users, when multiple hedge funds pile into the same stock, the concerted effort can push a stock price higher, and an early hedge-fund investor can reap extraordinary profits. Along these lines, ideas dinners have drawn a lot of scrutiny and suspicion. For instance, there were reportedly federal investigations in 2010 about whether or not another cabal of hedge funds was involved with a concerted effort to destroy the euro. No charges were ever brought

It seems that the tables suddenly turned, and what is going on among Reddit users seems eerily reminiscent of the 2010 idea dinners, except the dinners run 24–7 with unlimited seating on the cloud.

3. Can investors communicate with each other and then the marketplace about their reasons for buying stock or options in a company?

Of course, in general, that seems to me a matter of free speech. But free speech does not mean you can yell fire in a crowded movie house—or commit fraud. In general, if investors’ communication relates to lying, cheating, or stealing in connection with the purchase or sale of a security, that conduct can trigger SEC liability and also criminal liability, from both state and federal criminal authorities.

Also, certain information could be an unlawful tip—such as when an insider at a company shares material, nonpublic information with someone who trades on the basis of that information and profits. That scenario could be an example of unlawful insider trading.

There are also a range of rules and regulations that can impact investment chatter. For instance, for those who are registered as investment professionals, who work for publicly traded companies, especially during a securities offering being conducted by that company, or who hold other jobs involving communications, their speech might be subject to certain restrictions.

The bottom line is that people should be careful, thoughtful, and measured when talking about investing because the world of investing and investor communications does receive special scrutiny from the SEC and criminal authorities as well.

4. Can the SEC regulate speech that is not fraudulent?

There are important First Amendment concerns that can arise when the SEC starts investigating speech that is not fraud. Of course, the SEC has a duty to protect investors. However, it does not believe in momentum trading but instead preaches a much more fundamental approach to investing. The SEC warns that before buying a stock, investors should research the company and its leadership, read its filings, study its markets, consider its price-to-earnings ratios, evaluate its cash generation versus its debt load, review its earnings expectations versus reality, etc.

But in the end, the SEC cannot become the speech police and neither can Reddit. When it comes to dictating how to invest, the SEC job of preaching to investors is probably limited to just that—preaching (not regulating or enforcing).

5. Does the main reason for why you want to buy or sell a stock have to be making a profit on trading it? Could it be, for example, simply to squeeze hedge funds or punish a company for its environmental policies?

That’s a tough question. You can buy a stock for whatever reason you want—except you can’t buy a stock as part of a scheme to artificially distort the market for a security. For example, if a large shareholder of a publicly traded company decides to pay a bunch of investors to trade back and forth, creating the illusion of high volume and/or high stock-price changes, which they, in turn, hope to dump into the market at that artificially hyped price—that can be a pump-and-dump scheme, which is illegal.  

You also can’t buy a stock based on material, nonpublic information—that would be unlawful insider trading. You can’t buy a stock at certain times if you are an insider of a corporation, if by virtue of that position you are in possession of material, nonpublic information. You also can’t buy a stock based on information you learned when you deceptively hacked into a company and stole material, nonpublic information. Those are just a few restrictions as to when you can buy a stock. 

6. When does the SEC usually investigate and bring charges in this type of situation?

First off, when stock trading and social-media excitement generate national headlines, you can bet that the SEC will investigate—so the more notorious the conduct, the more likely the SEC will investigate. Second, when Congress begins holding hearings or pointing fingers, especially Congressional members of SEC oversight committees, the SEC will usually investigate. Third, when investor funds are at risk, whether because of Reddit users or hedge-fund shenanigans, the SEC will investigate.

Otherwise, SEC Enforcement decides whether to initiate an investigation based on many factors, including the magnitude and nature of the possible violations, the number of victims affected by the misconduct, the amount of potential or actual harm to investors from the misconduct, and whether misstated or omitted facts would have impacted investors’ investment decisions. SEC Enforcement also considers whether the conduct is ongoing or whether it occurred too long ago to pursue the full range of available remedies. 

SEC Enforcement may be more likely to initiate an investigation if the matter involves any of the following:

• requires immediate action to protect investors
• relates to conduct that may threaten the fairness or liquidity of the securities markets
• involves individuals with a history of misconduct
• involves a subject matter the SEC or Enforcement has designated as a priority
• fulfills a programmatic goal of the SEC and Enforcement
• concerns an industry practice that may be widespread and should be addressed

My next article will provide more answers and insights from my Q&A with John Reed Stark. It will cover what happens when the SEC investigates market manipulation, what kinds of stock-price touting are illegal, the legality of short squeezes, and more of the many topics raised by the Reddit/GameStop story.