Compliance lessons gleaned from GameStop market insanity

Using social media posts and Internet chat rooms, retail investors utilizing trading apps like Robinhood and E*TRADE sent the stocks soaring. GameStop’s value mushroomed from $2 billion to $24 billion in the space of a week, only to come tumbling down Thursday after several trading platforms began to limit trades on the stocks.

Regulators and lawmakers are taking notice.

Online trading platform users took to social media to call the trading limits unfair. Several members of Congress also complained, culminating in rare agreement between Rep. Alexandria Ocasio-Cortez (D-N.Y.) and Sen. Ted Cruz (R-Texas). Sen. Sherrod Brown (D-Ohio) tweeted Thursday that he would hold a hearing before the Senate Committee on Banking, Housing, and Urban Affairs on the “current state of the stock market.”

Phara Guberman, partner at law firm Paul Hastings, said the environment that led to the wild value swings in stocks like GameStop, AMC, and BlackBerry are the result of a “perfect storm.”

“We’re all working from home, you’ve got Robinhood and other platforms making it easy for retail investors to trade, and you’ve got a market that’s already volatile because of COVID-19,” she said.

The Securities and Exchange Commission (SEC) will likely examine the events surrounding these and other stocks for potential market manipulation, “through the lens of a pump-and-dump scheme,” Guberman said.

In a pump-and-dump scheme, investors make bets on whether a certain stock’s value will rise or fall, then issue public statements to encourage other investors to buy or sell that stock. Guberman said retail investors discussing their plans for stocks in chat rooms “is not much different from what trading desks have been doing for years.”

The difference would come if regulators could find false statements made by retail investors on social media and in chat rooms that were material to the stock’s performance.

“That will be hard to prove,” Guberman said.

Craig Moreshead, managing director of compliance consultancy firm Foreside, said in a typical investigation of extreme market volatility and suspected manipulation, “regulators would examine the transaction activity to determine who profited and whether there was any illegal conduct. This case raises a novel question whether someone can be charged with stock manipulation if there is no profit motive, but instead, the motive is some political message or to harm some other pool of investors (in this case, large Wall Street hedge funds with short positions).”

The SEC stated Wednesday it is “actively monitoring the on-going market volatility” without naming any particular stock of interest.

Amy Lynch, president of FrontLine Compliance and a former Financial Industry Regulatory Authority (FINRA) and SEC regulator, said the SEC could take action to curb the short selling that drove the wild fluctuations in price for GameStop and other stocks. “They could revise the rules around short sales and option trades to see if they can prevent this type of activity from happening again,” she said. “Rulemaking takes time, so in order to put a stop to this now, they may need to take immediate and strong action to simply ban short sales of certain ‘pandemic issuers,’ similar to how the EU banned short sales in early days of the pandemic.”

Compliance takeaways

Wild market swings caused by short selling is nothing new. In the past, it’s usually been one large investor or firm pitted against another. What’s new is that small retail investors, banding together on social media to align purchases of particular stocks, could have a noticeable effect on the market.

The compliance-related risks for broker-dealers and investment firms from social media-driven market volatility are threefold. There’s financial risk that a firm’s position on a certain stock might be imperiled; there’s regulatory risk, should regulators determine the firm’s employees—or the firm itself—were participating in social media-driven attempts to manipulate the price of a certain stock; and there’s reputational risk for a firm viewed by the public as taking advantage of the situation.

Carlo di Florio is a partner and global chief services officer at ACA Compliance Group and a former regulator at FINRA and the SEC. He said compliance officers at broker-dealer and investment firms would do well to review their policies and procedures on market manipulation.

“I think it’s worth reviewing your compliance effort on the effects of social media-driven market volatility,” he said.

Some questions worth asking: Are your employees buying some of these stocks on the side? Are they trading in these stocks on behalf of the firm? Either could be a red flag compliance officers should consider reviewing to ensure the trades were made in compliance with the firm’s policies and procedures.

“You want to make sure employees are doing what they are supposed to be doing—that they understand the policies and procedures and certify they are following them,” he said.

“Firms need to think about what controls they have in place, the rules they have in place, and the awareness their employees have about them,” Guberman said. “Careful review of internal policies is particularly important here.”

Firms that monitor their employees’ phones, texts, emails, internet activity, video conferencing, and other forms of communication should make sure they are not participating in some of the chat rooms where this retail trading takes place. Even more concerning would be if they were posting messages in these chat rooms, which could be seen as an attempt to manipulate a stock’s price.

Firms using data collection methods to monitor trends in the market may already be scraping data from certain social media accounts and chat groups, di Florio said. Compliance officers need to regularly review those sources and ask if it is a valid source.

Lastly, compliance departments should review the disclosures they are making to clients and fund investors about the risks of their investments, particularly the risks associated with the so-called “short pressure” being created when retail investors inflate the value of a certain stock.

“They need to understand their investments may be subject to short pressure. This is a pretty new manifestation,” he said.