SEC Staff Issues Report on GameStop and Other Meme Stocks

November 12, 2021

2021 was a year of unexpected—and sometimes baffling—events. In the midst of cascading economic failure caused by the COVID-19 pandemic and political turmoil, one cartoonishly-quirky episode swept the nation involving an unlikely main character: GameStop Corp (NYSE: GME). No longer the brunt of jokes about how little your used videogames are worth, GameStop became the talk of the internet for an altogether different reason.

GameStop’s story was long in the making before it became the darling stock of Reddit investors everywhere. A staple of millennial childhood, the once-ubiquitous and notoriously stingy video game retailer was pummeled by e-commerce. GameStop locations were going the way of Blockbuster at a rapid clip, and the rise of digital video game distribution allowed gamers to buy from online sources such as Sony, Microsoft, EA, Valve and Ubisoft. With the pandemic further suppressing in-person retail experiences, it looked as though GameStop’s days were numbered.

In response to GameStop’s readily apparent financial woes and difficulty finding a footing in the age of e-commerce, many on Wall Street did what any good investor would do—shorted GME stock.

What happened next in January 2021 is the subject of two different narratives. The first—a classic story of David and Goliath—evolved virally on Reddit, Twitter and YouTube. According to this narrative, armies of individual investors, fed up with the treatment hedge fund managers had been affording certain ailing companies, took to popular broker-dealer platforms like Robinhood to give Wall Street a taste of its own medicine. On social media, particular emphasis was placed on a “short squeeze” to explain the astronomical rise of GME’s stock price. In a short squeeze, hedge funds and investors who had been mercilessly shorting GME stock would be forced to close out their positions against GME to avoid catastrophic losses in their investment. Closing out these positions would further drive the price of GME up, putting further pressure on investors who chose to maintain short positions.

In at least one instance, it seemed like investors on social media platforms, particularly Reddit, achieved this goal. One hedge fund, Melvin Capital, was forced to take an enormous loss to close out its GME short position. Melvin lost 49% on its investments in the first quarter of 2021, and nearly $3 billion had to be infused into the company to shore up its finances.

Such a story seems fit for Hollywood. The second narrative of what happened with GME is much less so. In its Staff Report on Equity and Options Market Structure Conditions in Early 2021 (the “Report”), the Securities and Exchange Commission breaks down the elements that led to GME’s astronomical rise—drawing many surprising conclusions.

First, the SEC staff concluded that a short squeeze does not adequately explain what happened. Although individual investors out for revenge make for good headlines, it is an oversimplification of the factors that drive the rise of meme stocks like GME. In the Report, the SEC wrote that GME benefited from the confluence of five major forces. GME experienced large price moves, large changes in trading volume, large short interests, frequent social media mentions and significant media coverage.

All of these factors worked together to produce a chain of events where the price of GME initially spiked due to a bullish spark, a wave of investors drove the price up further still due to FOMO (“fear of missing out” on potential profits) and loyal and united investors held the price up by maintaining large positions.

The Report further concludes that popular broker-dealers—such as Robinhood—had good cause to limit trading of meme stocks like GME. Such a claim runs contrary to the popular narrative. Robinhood’s temporary limitation on trading meme stocks sparked outrage among individual investors and led to Congressional hearings. With the short-squeeze narrative prevailing online, the limitations made it appear that many broker-dealers were siding with the hedge funds—attempting to halt the squeeze.

But the SEC staff explained that the more likely motivation behind the temporary limitations was to mitigate risk exposure on the clearinghouse level. With a stock price whipsawing back and forth, clearing agencies may demand broker-dealers increase the cash margins they maintain with the agency to guard against defaults by buyers and sellers of a volatile stock. If a broker-dealer is unwilling to do that, it may attempt to limit trading of that volatile stock instead.

Closing the SEC staff’s striking analysis of a unique situation is a gleam of positivity. The Report ends with a reminder that although some investment apps make the stock market seem like a game with heroes and villains, underneath the memes are actual companies, employees, customers and plans for investment in the future. The meme stock boom of January 2021 tested the capacity and resiliency of the nation’s market systems and revealed a new generation of investors. The Report’s most significant conclusion is that working to address weak points in the market system, such as how meme stocks are handled, can make the market a safer, more fair and orderly place.

If you have questions or would like to discuss further, please reach out to Christopher Hubbert at cjh@kjk.com or 216.736.7215.