The financial news headlines at the start of 2021 have been dominated with this year’s very own David and Goliath story – GameStop.
For those who may have missed the flurry of press reporting, Melvin Capital, a $13 billion hedge fund, was left with more than just a bloody nose after a group of Reddit users on a message board called WallStreetBets banded together and took revenge on large hedge funds that had taken out hefty short positions in GameStop, an ailing video game retail chain. Galvanising each other, these amateur investors made mass purchases of GameStop shares, drastically pushing up the price and causing colossal losses to those with large short positions, including Melvin Capital, who was forced to seek a rescue package. Buoyed by this (at least temporary) success, the phenomenon began to spread, with other heavily shorted companies across the globe targeted by Reddit-inspired individual investors with the single-minded aim of bringing down hedge funds.
In the wake of this action, institutional investors have complained that WallStreetBets participants appeared to be getting away with making claims and inciting others in a way that would not be tolerated if carried out by City or Wall Street traders. Questions were raised about the legality of amateur investors banding together and using social media to inflate stock prices. The US Securities and Exchange Commission (‘SEC’) announced in a lengthy statement that it was working to “identify and pursue wrongdoing”, making reference to abusive and manipulative trading activity. Shortly thereafter the Financial Conduct Authority (‘FCA’) stepped in and issued their own (comparatively anodyne) statement, the relevant part being: “Firms and individuals should also ensure they are familiar with, and abiding by, all regulations including the market abuse and short selling regimes in the jurisdiction they are trading in.”
It is interesting that this statement implies that, in deciding whether to intervene, the FCA will be looking at both sides of the market and that accordingly both amateur and professional investors may find their actions under scrutiny. However, while both regulators are clearly trying to understand exactly what has happened and how, the FCA’s statement is notable for its complete lack of detail as to what either side of the market may have done wrong. That is because, in seeking to sanction either David or Goliath, there are a plethora of potential obstacles the FCA would have to overcome.
The first, and perhaps most obvious, potential ground on which the FCA could bring action would be breaches of the Market Abuse Regulation (‘MAR’). MAR specifically prohibits three main forms of market abuse: insider dealing, unlawful disclosure and market manipulation. It is the last of these, covered by Article 12 of MAR, that will be of most interest to the FCA in these circumstances.
Article 12 defines four activities as market manipulation. Two of these are relevant for present purposes. Article 12(1)(a) prohibits entering a trade which gives, or is likely to give, false or misleading signals as to the supply of, the demand for, or the price of, a financial instrument (unless the person establishes that such a transaction has been carried out for legitimate reasons and conforms with an accepted market practice). Article 12(1)(c) prohibits the dissemination of information (including rumours) by any means which gives, or is likely to give, false or misleading signals as to the supply of, the demand for, or the price of, a financial instrument, or is likely to secure the price at an abnormal or artificial level, where the person who made the dissemination knew or ought to have known that the information was misleading.
Both types of market manipulation rely on the concept of misleading signals. Here arises the first obstacle for the FCA. The introduction to MAR makes clear that the reason for outlawing market manipulation is because it “prevents full and proper market transparency” (paragraph 7). These provisions, with their focus on misleading signals, were therefore designed to deal with (a) those giving patently false signals to the market, such as spoofers, who indicate to the market that they are intending to buy or sell a share (thereby moving the price in a certain direction) when their true intention is to do the opposite, and (b) commentators deliberately propagating false information in order to cause people to invest, believing they will make money as a result. This situation is different. The purchases of GameStop shares were legitimate transactions, representing the demand of a large group of individuals. The information shared on the message boards was not designed to mislead anyone about the financial health of GameStop. In short, the regulations were plainly never written to punish the trader whose underlying motive is either to damage the standing of a short-seller, or to undermine the whole edifice of the system within which stocks are traded. Their actions do not neatly fall within what is envisaged by Article 12 of MAR.
That said, this group of traders is not a homogeneous group. Whilst many are buying stock hoping only to give hedge funds a bloody nose, there will undoubtedly be some in the crowd who are acting in bad faith. Indeed, there may well be individuals contributing to Reddit discussions encouraging and claiming to participate in the mass purchase, who are themselves taking short positions, waiting for the likely fall in the price of GameStop stock once the buying frenzy stops. Their liability for contravening MAR may be more clear-cut.
But this is where the FCA would face the second obstacle – proof of intention. Posts on message boards are under anonymous usernames, and tracing individuals who said one thing and then acted differently would be extremely difficult.
There are also obstacles of both policy and politics for the FCA to consider, which could potentially pull in opposite directions. MAR was introduced in 2016 with the dual aims of strengthening investor protection and market integrity. Huge, unsustainable price rises in the stock of ailing companies can hardly be described as an orderly market. If the FCA is to show any teeth in its role as a regulator trying to maintain market integrity, it may feel compelled to take some action.
On the other hand, the political context would make it hugely controversial to pursue amateur individual investors in a context where institutional traders were largely protected from any sanction following the financial crash. Failing to take action against professionals whilst penalising armchair investors would therefore be to reinforce precisely the criticisms that are made of the financial system by many of those participating in the Reddit message boards.
Short Selling Regulations
Amateur investors can however take some comfort that the “big guys” may find themselves in the FCA’s sights for breaches of the Short Selling Regulation 2012 (‘SSR 2012’). The SSR 2012 applies to the short selling of sovereign debt, shares (and related instruments) admitted to trading on a UK trading venue and the use of credit default swaps. Amongst other things, the SSR 2012 requires investors to make notifications to the relevant regulator (in the case of the UK, the FCA) once certain thresholds have been crossed. 
At the tail end of last year, the FCA took its first action in respect of SSR 2012 against Asia Research and Capital Management Ltd (‘ARCM’). ARCM, an asset management firm, had apparently been unaware that the disclosure requirements of SSR 2012 related not just to shares but also to derivatives. It should therefore have disclosed to both the FCA and the public the huge short positions it had built up in Premier Oil, a company admitted to trading on the London Stock Exchange.
The FCA issued a Final Notice and fined ARCM £870,000, which Mark Steward stated: “reflects the seriousness of these breaches.” What is interesting is that ARCM was based in Asia rather than in the FCA’s main hunting grounds of England, mainland Europe or America, and that despite the firm self-reporting the breaches as soon as the mistake was recognised, the FCA still decided it was necessary to take action. The financial watchdog was clearly baring its teeth to the market.
Those who have been taking on the hedge funds giants will probably be hoping that the FCA warning statement, coupled with the ARCM outcome, will signal an aggressive pursuit by the FCA of any marketplace Goliaths revealed to have broken the short selling rules in the run up to this extraordinary episode of market turbulence.
Whilst there is a plethora of obstacles facing the FCA in taking any action under MAR, it would be even more difficult for the regulator to take criminal action. The most obvious criminal offence is Section 90 of the Financial Services Act 2012, namely that of creating a false or misleading impression as to the price or value of a relevant investment. However, the intention of the trader is paramount here. To be guilty, the person must intend to create a false or misleading impression. The problems discussed above in providing the regulatory concept of “misleading” are therefore present to an even greater degree in proving the criminal mes rea. Reddit traders acted explicitly and proving any intention to mislead would be very difficult.
Whilst the FCA was quick to put out a warning statement, it will find that taking enforcement action, whether regulatory or criminal in nature, will be anything but straightforward. It is ironic that, whilst MAR was brought in with an eye to increased automation and algorithmic trading, together with the explicit warning that the measures are “capable of being adapted to new forms of trading or new strategies that may be abusive” (paragraph 38), they do not provide a clear pathway to punish a group of amateur traders banding together in a relatively old-fashioned manner. For now, we will just have to wait and see which giant these armchair Davids will next seek to slay and whether the FCA will choose to enter the arena to ensure fair play.
Claire Cross, Partner
Maia Cohen-Lask, Senior Associate
 The SSR 2012 also confers powers on the FCA to address adverse events or developments that pose a serious threat to financial stability or market confidence in the UK. These powers however relate only to ensuring short selling is not causing serious damage to the markets. It does not deal with the converse, as here, where short sellers are the ones facing the detriment.