September 21, 2021

Volume XI, Number 264

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September 21, 2021

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September 20, 2021

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Rupture Rapture: Should the GameStop?

GameStop, a company described on January 26, 2021, in the Wall Street Journal as a “moribund mall retailer” that sold electronic games, but not very many with the closing of malls as a result of the growth of e-commerce, and even fewer after the shutdowns of non-essential shopping stores due to COVID, has seen its stock (listed on the New York Stock Exchange) share price rise in the last year from a low of $2.57 to $483.00. Almost all of that gain has occurred since Friday, January 22, 2021. What business development caused this? The simple answer to that question is NONE.

Rupture Rapture

Value and pricing have always been a part of capital markets. According to Aristotle in “The Politics” (Book I, Section 1259a) Thales of Miletus (c. 624 – c.548 BC) the pre-Socratic Greek mathematician, astronomer, and philosopher from Miletus in Ionia (now the Southwestern part of Turkey) had been taunted about the uselessness of philosophy, as he was quite poor. But Thales recognized from his astronomical studies in that 6th century BCE year, that although it was still winter, there would be a “bumper” crop of olives. He raised a small sum of money and made deposits on all the olive presses in Miletus and the surrounding area. When the crop came in he controlled the presses and let them out (in the face of great demand) at prices he set, thereby making a substantial profit. Thales had “cornered” the market for olive presses; he set the pricing and he acted to prove that philosophers could be wealthy. So, his motives were both to accumulate wealth and status.

These two human needs: the desire for wealth and the desire for recognition have been the principal motivations across human history for certain market events. In the Golden Age in the Netherlands in the 17th century, the ownership of beautiful tulips was the indicator of status, as by 1637 the price for some bulbs reached ten times the average annual income. This phenomenon was the basis for the Scottish journalist, Charles MacKay’s famed book (seen as the first socio/psychological study of market behavior) “Extraordinary Popular Delusions and the Madness of Crowds.” In 1711, a joint-stock company was organized in London to deal with British national debt and, after a 1713 grant of monopoly power, to supply slaves to the Caribbean islands where sugar cane was grown. That company (formally known as The Governor and Company of the merchants of Great Britain trading to the South Seas and other parts of America, and for the encouragement of the Fishery; and informally as The South Sea Company) began to deal in government debt arising from the War of Spanish Succession. Almost all the war expense was privately financed and, indeed, even the Bank of England was a private company. Seed capital was raised with a lottery and by 1719, shares were offered to the public. Gripped with speculative frenzy the share price rose from L 128 in January 1720 to a peak of almost L 1000 by summer, as everyone who was anyone fought to buy shares for fear of missing out on the expected great wealth. In the subsequent collapse, millions of pounds were lost, including as much as L 22,000 by Sir Isaac Newton who famously wrote: “I can calculate the movement of the stars, but not the madness of men.” The collapse of the South Sea Bubble led to the passage in 1720 of the Bubble Act which prohibited the formation of a joint-stock company without a royal charter.

In the United States, one of its first financial crises (after the success of Alexander Hamilton in nationalizing the debt after the victory against Great Britain and Washington’s resolution of the 1791-1794 Whiskey Rebellion) was the Panic of 1837, when speculative lending for land purchases in what is now the Midwest coincided with a sharp drop in cotton prices, and the real estate bubble burst. The real estate speculators had been seeking wealth and prestige that were presumed to flow with land ownership. This probably was the cause of Martin Van Buren, being a one-term president, as he was seen as slow to attempt to stabilize the market. After the recovery from 1837 and the chaos and death of the Civil War 1861-1865, America embarked on a Gilded Age in the 1870s and 1880s, the time of great industrial growth, especially in railroads (the Golden Spike was driven in Provo, Utah in 1869 to create transcontinental rail connections), and the rise of the so-called Robber Barons. Then, in 1890, the wheat crop in Argentina (whose international financial agent was the British firm, Baring Brothers) failed along with a political coup in Buenos Aires caused European investors (brought in by Baring Brothers) facing losses to trade in their investments in American stocks and holdings of dollars for physical gold. The resulting Panic of 1893 saw the collapse of over 500 banks and the bankruptcies of the Union Pacific, the Northern Pacific, and the Atchison, Topeka & Santa Fe Railroads. Unemployment reached 25% in Pennsylvania, 35% in New York, and 45% in Michigan. All this followed from what turned out to be a less than wise series of investment decisions by persons seeking wealth and with its position.

Once again in 1906, some very wealthy New Yorkers sought to increase their wealth by cornering the market on the stock of United Copper Company. Their effort was financed by loans from a number of New York City banks, led by borrowings from Knickerbocker Trust Company, New York’s third-largest bank. Also in 1906, Congress passed the Hepburn Act which created the Interstate Commerce Commission (“ICC”) to regulate railroad operations, including pricing. As the ICC assumed its activities, the prices of railroad company stocks fell. When the effort to corner the stock in United Copper failed in October 1907 the prices of shares traded on the NYSE plummeted 50% over three weeks from their 1906 highs. This was the so-called Knickerbocker Crisis (also known as the Panic of 1907), which caused the financial system to freeze until J.P. Morgan single-handedly organized the New York banks to save the American financial system. His success and the concern that there might not always be someone of his stature and wealth to “save the day” led to the passage in 1913 of the Federal Reserve Act and the creation of the Board of Governors of the Federal Reserve System (the “Fed”). Once again speculating investors had been seeking increased wealth and market power, and the prestige that comes with them.

After World War I, the United States breathed a collective sigh of relief as the country enjoyed an explosion of pent-up demand that led to the wealthy excesses of the “Roaring Twenties” so well captured in the works of F. Scott Fitzgerald. The Dow Jones Industrial Average increased six-fold from August 1921 until September 1929, and the Fed’s warning in March 1929 of excessive speculation went largely unheeded. It was said that even shoeshine boys and cab drivers were buying stock expecting (and hoping) to get rich. Some of this was also driven by a fear of losing out on great opportunities. As the famed international economist, Charles Kindleberger, has observed “There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich. Unless it is to see a non-friend get rich.” The excessive speculation ended in the Crash in October 1929 and the onset of the Depression. This, in turn, led to the New Deal and the enactment, among many other pieces of Federal legislation, of the Glass-Steagall Act of 1933 (separating commercial banks from investment banks), the Securities Act of 1933, and the Securities and Exchange Act of 1934 (which created the Securities and Exchange Commission (“SEC”)).

After the United States recovered from the Depression, with the assistance of the economic necessity brought on by World War II, the economy once again began to hum as the Eisenhower administration promised “Peace, Progress, and Prosperity.” Despite the continuing Cold War America was thriving, and with that came waves of technological innovation, so that in the 1960s almost any company which ended in “tronics” as in “electronics” was seen as a winner. Once again investors drove up the prices of the so-called “Nifty Fifty;” companies whose stock would always gain at market price. Frequently, investors were disappointed. Then by 1994, some very bright men, including two Nobel Laureates, started Long-Term Capital Management (“LTCM”), which used computer algorithms to create portfolios using stocks and options. After achieving stunning returns for three years in 1998, LTCM lost $4.6 billion in four months as a result of the Russian financial crisis which had not been factored into their computations. The stock market fell precipitously and the American (and indeed, the world), the financial system almost came “unglued.” The Fed organized a rescue by raising $3.6 billion from 14 of the largest banks in the world. LTCM was liquidated in 2000, just in time to observe the famed “Dot.Com Bubble” burst in March 2000, after stocks traded on NASDAQ rose 400% from 1995 prices. Once again, investors chasing wealth and prestige, fearful of losing out on the “hot new thing” of Internet companies “rushed in where angels feared to tred.”

In a financial collapse, redux brought on by the “irrational exuberance” about homeownership and home speculation the worldwide Great Recession of 2007-2008 so graphically captured in the book and movie “The Big Short” brought bankruptcy and ruin to many who had sought wealth and prestige. People who could not afford the debt payments were allowed to borrow money to buy houses, the lending banks were not terribly concerned because Wall Street investment bankers had invented a way to package and resell mortgage loans in engineered pieces to institutions and to individual investors. Because they were pieces of mortgage loans they were seen as very secure and were in fact rated that way by the major rating agencies, When the bubble burst with the collapse of investment banks Bear, Stearns, and Lehman Brothers, the near bankruptcy of American International Group, the failure of Washington Mutual Saving Bank and Wachovia, the receiverships for Fannie Mae and Freddie Mac, and the regulatory enforced takeover of Merrill Lynch, unemployment soared and the United States Government, including the Fed, had to pump billions into the economy to stabilize it. The Great Recession also resulted in the passage of the Dodd-Frank Act, which added material constraints on many aspects of the financial system. Once again persons striving for the wealth associated with homeownership and the accompanying sense of belonging, along with bankers and service people eager to obtain outsized returns drove behavior, which in hindsight, turned out to be an extraordinary chain of bad decisions.

Even in the well-recognized market frauds using so-called “Pump and Dump” schemes, the motives are to obtain wealth. The fraud promoter selects a stock and issues all kinds of positive (not factually based) news and opinions aimed at getting investors to push up the price of the stock for fear of losing out on a “good thing.” Then, when the price is high enough the promoter “dumps” the shares on the enticed, eager, and unsuspecting, public. This type of fraud typically has involved “boiler rooms” and was graphically captured in the 2000 film of the same name. One of the most “famous” of these “boiler room” firms was Stratton Oakmont, whose co-founder, Jordan Belfort, turned his resulting criminal conviction into the basis for the Academy Award-nominated film, “The Wolf of Wall Street.” Here again, the outsized desire for riches and prestige led to very bad results.

Should the GameStop?

So what did/do the investors in GameStop (and a few other stocks) see that lures them into driving its price and the prices of some other companies unbelievably high? Since the March 2020 onset of the COVID pandemic actions by the Fed and Congressional legislation have pumped extraordinary amounts of money into the economy, much of it into the hands of individuals. As a result of the pandemic, much of the nation’s economy has been in a shut-down mode for ten months. The amount of sporting events has been greatly reduced and only a few fans in a few venues are allowed to attend in person. Travel other than by personal auto or private jet is quite a challenge, and there are NO cruises. On the other hand, casinos and on-line gaming have seen rapidly growing use as people try to overcome the boredom and sense of confinement brought on by the various shutdown orders. At the same time a Romanian immigrant, Vlad Tenev, and his co-founder started Robinhood Capital Management, a stock brokerage that reportedly allows one to buy and sell securities, including options without fees. Trading is done electronically and is apparently strongly embraced by younger investors. Indeed, one market commentator (Jim Cramer of CNBC’s “Mad Money”) has dubbed the many new retail investors using Robinhood and other inexpensive trading platforms the “Merry Men.” This all is occurring in a time of tremendous growth and use of social media, including the ability to “organize” so-called “flash mobs” and even the January 6, 2021, attack on the U.S. Capitol. MacKay’s observations about “the Madness of Crowds” may be particularly relevant to any attempt to understand these phenomena.

We know from statements on Twitter and text messages received by commentators on CNBC’s “Squawk Box” as well as those quoted in the Wall Street Journal that many if not most of the “investors” driving up the price of GameStop and the other companies involved are not interested in making money. They have been “organized” into the equivalent of a “flash mob” by statements on the Wall Street Bets sub-platform on the media platform sponsored by Reddit, a recently formed social media company. What drives them is learning that hedge funds that specialize in taking short positions in stock have sold billions of dollars worth of stock in these companies, where the hedge funds (often owned and controlled by billionaires) do not own the stock. Short selling is a gamble that the price of a stock will decline, and when the stock is not owned (a so-called “naked short”) the funds can lose billions if the price instead rises. Short selling does serve as an effective check on pricing exuberance. Apparently quite a number of the so-called “Reddit Mob” members had lost money when investments they made (e.g., reputedly in Nikola Corp.Wirecard AG, and Valeant Pharmaceuticals International, Inc., to name a few) when the stock of those chosen investments declined in value after short-sellers took their positions and published investment reports explaining why they thought the stock was overpriced. The “Reddit Mob” with the time, boredom, money, and participatory technological skills had collective anger and a sense of having been taken advantage of by billionaires who looked down on Mob members. They “organized” a series of what is known as a “Short Squeeze” to break or bankrupt the short-sellers. According to David Kostin of Goldman, Sachs & Company, Inc., in a February 1, 2021, report this is the biggest “Short Squeeze” in 25 years. And they have succeeded: one fund, Melvin Capital, reportedly sold out of its GameStop short position, taking a loss of 53% of its asset value (over $3 billion). Melvin Capital only survived after a capital infusion from two other funds, Citadel Capital Management, which lost 3% of its value, and Point 72, which lost 10% of its asset value. Citadel happens also to be an investor in Robinhood. Another short seller, Andrew Left’s Citron Research, announced that after 20 years of short investing and publishing opinions on shortable companies will do so no longer due to the threats of physical violence to him and to his family members, which the FBI is reportedly now investigating.

When Robinhood suspended the ability to trade stocks in 13 companies including GameStop on Thursday, January 28, 2021, its clients went wild, multiple class-action suits have reportedly been filed, and at least one person, David Portnoy of the online gambling company Bar Stools, accused Robinhood of “kowtowing” to the demands of a hedge fund (namely Citadel). In fact, it appears that Robinhood had a potential liquidity problem. Broker-dealers (“BDs”) like Robinhood, do not close the trades they handle. That is done by clearing firms, the most significant of which is the Depository Trust Company (“DTC”). DTC and other clearing firms require BDs to post cash collateral (cash or Treasuries, etc.) against the risk that transactions do not close. The amount required to be posted depends on several factors, including the price of a stock; the volume of trades in that stock; and the rate of price increase or decrease in the short run. DTC required Robinhood to put up substantial additional cash collateral in order to continue trading GameStop and other affected securities. Other BDs faced similar requirements. In the case of Robinhood, it reportedly raised $1 billion overnight and reopened trading in those stocks on Thursday the 2r, although with some limitations on permitted volume. However, the anger and outrage are more than evident, including caustic criticism from Rush Limbaugh (quoted in the New York Post), and Senators Elizabeth Warren and Ted Cruz. As of Monday, February 1, 2021, Robinhood has reduced the number of stocks still subject to trading limits to eight.

Some market participants and Alexis Ohanian, co-founder of Reddit, have asserted that this is all a result of “democratizing” the capital markets and net positive for the future. A report in the weekend edition of Wall Street Journal, for Saturday and Sunday, January 30-31, 2021, identified a 34-year-old former Massachusetts Mutual Life Insurance Co., marketing employee as the on-line “influencer” who triggered the interest in GameStop. He reportedly began buying GameStop shares at about $5 each in July 2019, seeing a chance that it might gain in profits through better use of e-commerce. But as he talked up his ideas on internet chat rooms, including Wall Street Bets, other “investors” joined in.  This in turn provoked short-selling hedge funds to enter the fray. The hedge funds were gambling that GameStop had little “real” value above $5.00 per share so that they would profit when the market price returned to its July 2019 level. This enraged the “Reddit Mob” and through constant use of social media, they formed an investment bloc, albeit without objective structure.

American capital markets have since the beginning of economic studies relied on the self-control imposed on individuals by their own self-interest. That was and is the notion behind the idea of “The Invisible Hand” in Adam Smith’s “The Wealth of Nations.” Almost all of the regulations applicable to the capital markets rely on creating costs (both economic and reputational) for violations that generally deter misbehavior. Indeed, that fundamental precept is reflected in the cost/benefit analysis required as part of any new regulatory proposal. But the “Reddit Mob” is apparently NOT price-sensitive; i.e., they say that they do not care if they lose every dollar they spend, as long as the short sellers are routed. As Christopher Mims wrote in the weekend edition of the Wall Street Journal of Saturday/Sunday, January 30-31, 2021 (page B 4) “The Wall Street Bets members …are [an example of] what philosophers call “closed epistemic systems,” worldviews that are unaffected by the information that contradicts them. Its confirmation bias on steroids. It’s also the logic of a cult.” Those characteristics present an urgent need to reevaluate the traditional regulatory approach. There are some things that can readily be done, probably without legislation;

  • Greater transparency of short position sizes and holders, more immediately available (as is already the case in European markets)

  • Limitations on how much of a company’s stock can be shorted, even in a “naked short” to a maximum of the total or some percentage of the total number of shares outstanding (in some cases short-sellers have shorted more shares than exist)

  • Limitations and/or prohibitions on the use of options to increase the impact on pricing

  • Limit or end the ability to buy selected stocks on margin

  • Greater authority of regulators and/or exchanges to suspend the trading ability of specific shareholders, in addition to the authority to suspend trading in specific securities

Beyond these, new constraints need to be designed and implemented to constrain “Reddit Mob” attacks anywhere in the market. Under the 1968 Williams Act amendments to the Securities and Exchange Act of 1934, as amended, a person OR GROUP acting in concert who acquires 5% or more of the stock of a public company, must file disclosure documents with the SEC including an indication of intentions. In antitrust law, the concept of “conscious parallelism” is well-recognized as a basis for finding a “conspiracy in restraint of trade.” One wonders whether the SEC might espouse a similar view with respect to the “Reddit Mob,” such that their parallel (yet collective) actions might allow regulatory sanctions for actions that would be seen as suspect if done by a single individual. The SEC did issue a statement on Friday, January 29, 2021, which said (in part):

The Commission is closely monitoring and evaluating the extreme price volatility of certain stocks’ trading prices over the past several days. …[E}xtreme price volatility has the potential to expose investors to rapid and severe losses and undermine market confidence.

Nietzsche warned, beware the attack of the sheep, (here organized on social media and seeking the rapture of revenge). Let us hope that the SEC will yet be the Good Shepherd.

©2021 Norris McLaughlin P.A., All Rights ReservedNational Law Review, Volume XI, Number 33
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About this Author

Peter D. Hutcheon Corporate Governance Lawyer Norris
Of Counsel

Peter D. Hutcheon practices primarily in the areas of business governance, commercial transactions, securities, banking, and finance.

Peter counsels management of public and private companies and banking institutions on governance matters.  He also has particular expertise with respect to indemnification and insurance issues affecting directors and officers.  Peter has represented parties in major public-private partnership financings.  He also represents clients seeking investment capital from private placements, venture capital, and private...

(908) 252-4216
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