GameStop Invites Greater Scrutiny Into Online Communities – Litigation May Follow
This article was written for The New Orleans Bar Association and was published April 14, 2021.
The recent meteoric rise of GameStop (GME), followed by its quick fall, highlights the power online trading communities can exercise on the price of thinly traded stocks in a world of no-fee, gameified trading apps. By banding together on social media groups like r/WallStreetBets, individual investors can wield the type of economic influence that has historically been reserved for Wall Street. However, this activity is likely to receive a lot more scrutiny from the SEC and Plaintiffs Bar going forward. Indeed, since January, the SEC has suspended trading of more than a dozen securities following “questions about recent increased activity and volatility in the trading [and] the influence of certain social media accounts on that trading activity.” See SEC Suspends Trading in Multiple Issuers Based on Social Media and Trading Activity. Thus, for those considering joining the community of online investors, caution is advised.
Rule 10-b(5) of Securities Exchange Act of 1934 prohibits “any person, directly or indirectly, by the use of any means or instrumentality . . . to employ any device, scheme, or artifice to defraud [or] to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.” The term “person” is defined in the 1934 Act to include “a natural person, company, government, or political subdivision, agency, or instrumentality of a government.” The term “company” is further defined in The Investment Company Act of 1940 as a “corporation, a partnership, an association, a joint-stock company, a trust, a fund, or any organized group of persons whether incorporated or not . . . .” Courts interpreting the definition of “company” have refused to limit it to recognized business associations. See, e.g., Prudential Ins. Co. of Am. v. Sec. & Exch. Comm'n, 326 F.2d 383, 387 (3d Cir. 1964). Consequently, Rule 10-b(5) holds out the possibility that members of a social media group could be held responsible for coordinated, fraudulent activity.
Social media has made it easier for average investors to participate in fraudulent securities activity like pump-and-dump schemes, which involve “artificially inflating the price and volume of an owned stock—by promotional or trading activity—to sell the stock at a higher price.” United States v. Curshen, 567 F. App'x 815, 816 (11th Cir. 2014). After the overvalued shares are “dumped” back into the market at a profit, “the price and volume of shares plummet and unsuspecting investors lose their money.” Id.
There are several ways that this type of fraud could be perpetuated by online communities. For example, members of a Facebook group might conspire to buy heavily into ABC Company to emulate genuine trading interest in the stock. After other investors purchase the stock at an inflated price, the members of the Facebook group sell—causing the stock price of ABC
Company to plummet and the newest investors to suffer significant losses. This type of activity could have been at the root of the SEC’s decision to suspend trading of securities in Marathon Group Corp. (PDPR) on Feb. 19, 2021, when it found that “trading volume ha[d] increased in the absence of any publicly available news or current information from the Company, and certain social media accounts may be engaged in a coordinated attempt to artificially influence PDPR’s share price.”
In another example, members of a Reddit community could post statements about a short-squeeze opportunity for ABC Company and encourage the public to purchase stock in ABC Company to help squeeze the short positions. This was the strategy employed by members of r/WallStreetBets during the GameStop short squeeze. See Michael Hiltzik, Explaining the Reddit-fueled run on GameStop, LA Times, Jan. 26, 2021. However, in this example, there is no short-squeeze opportunity. Instead, the claim is invented solely to induce a buying frenzy. ABC Company’s share price rises rapidly following the dissemination of the fake short-squeeze news on social media by members of the Reddit community. Before the lie is revealed, members of the Reddit community dump their shares at an inflated price.
In this latter scenario, it would be difficult to prove that members of the online community who merely bought and sold the stock had the fraudulent “intent or severe recklessness” required to be held liable for a Rule 10-b(5) violation. However, any individuals who commented on, liked, and reposted the fraudulent statements without making an effort to verify the accuracy of the allegations might invite more scrutiny. See Lorenzo v. SEC, 139 S. Ct. 1094 (2019) (holding that disseminating false or misleading statements can fall within scope of Rule 10-b(5)).
These examples represent only a small fraction of the conduct regulated by the 1934 Act. As social media trading strategies continue to expand and evolve in the coming years, fraudulent conduct by online communities is inevitable. How that fraud will be addressed by regulators and securities lawyers, however, is not easy to predict. So, until there is more guidance in this area, investors would be wise to think twice about what they “like” and share online.
Please contact Harrison Golden or any member of Phelps’ Litigation team if you have questions or need advice and guidance.
