SEC Needs to Act on GameStop: Valliere

Though the Securities and Exchange Commission may not want to deal with the trading frenzy surrounding video game retailer GameStop, it likely will have to do so anyway, according to Washington insider Greg Valliere, who is chief U.S. policy strategist for AGF Investments.

The regulator "may have no choice because officials know this could end badly for the financial markets and individual investors," he wrote in his latest Capitol Insights blog post Thursday.

"After years of overlooking predatory hedge funds that have hammered fragile companies into extinction, the SEC is hearing from hedge funds that now want protection — as the hunter becomes the hunted," Valliere explained.

The burst in the trading and price of GameStop and AMC shares "has gotten Washington's attention. Treasury Secretary Janet Yellen has her first crisis, just two days on the job, and even the White House is monitoring this," he added.

"No one in the new administration wants to see market instability; the focus here is still on COVID-19," Valliere stated.

Over the past week, a wave of trading fueled by members of the Reddit group WallStreetBets pushed up the stock of GameStop — a wave that has since spread to other stocks heavily shorted by hedge funds, including movie chain AMC and phonemaker BlackBerry.

The volume of GameStop shares surged to over 177 million on Monday and Tuesday, dropping to a still-high 91 million on Wednesday and 42 million on Thursday.

Meanwhile, its stock rose more than 620% from late Friday, when it traded at about $65 per share, to $469 per share in intraday trading Thursday; however, the shares were down nearly 30% for the day on Thursday afternoon, trading at $250.

The SEC said in a statement Wednesday that it is "working with our fellow regulators to assess the situation and review the activities of regulated entities, financial intermediaries, and other market participants."

What's Next?

While we aren't at the level of distress we saw during the 2008 financial crisis, the current turmoil "could end badly for small investors and hedge funds; meanwhile, ordinary investors could become apprehensive," he says. "The SEC needs to cool this crisis, but how?"

The SEC would need to prove criminality, which means officials have to show "an organized effort to manipulate stocks up or down," Valliere said. "A key issue: is this just a populist Reddit revolt against hedge funds or a 'pump and dump' get-rich-quick scheme?"

Proving market manipulation will be "extremely difficult, unless the agency can prove that the traders had the required level of intent, and/or engaged in an illegal pump and dump scheme that involved false or misleading statements," Ken Joseph, head of the disputes practice at the law firm Duff & Phelps said Thursday.

"Merely buying stock to squeeze short sellers is not illegal," Joseph added. And actions against Reddit users "will be equally difficult" for the reasons he explained earlier. "Among other things, these posters may qualify for protection under the First Amendment to the extent they are expressing opinions about the stocks involved."

So far, hedge funds have likely lost about $24 billion in their short positions in GameStop, Valliere points out. "They can unwind the holdings, but they'll also require "even more cash infusions from solvent firms."

As for the Washington angle, it's "virtually certain that [Massachusetts] Sen. Elizabeth Warren and other industry critics will demand SEC prosecution which — Warren hopes — would result in steep fines and disgorgement of profits," according to the political expert.

"For years, the same hedge funds, private equity firms, and wealthy investors dismayed by the GameStop trades have treated the stock market like their own personal casino while everyone else pays the price," Warren said Wednesday. "It's long past time for the SEC and other financial regulators to wake up and do their jobs — and with a new administration and Democrats running Congress, I intend to make sure they do."

On Thursday, Sen. Sherrod Brown (D.-Ohio), the incoming Senate Banking Chairman, said he intends to hold a hearing on the "current state of the stock market," referring to the intense trading of GameStop and other firms: "It's time for the SEC and Congress to make the economy work for everyone not just Wall Street."

In general, the trading frenzy likely won't end well for speculators, "but the economic fundamentals still look solid," Valliere said, adding that he doesn't think the trading situation will spill over to broader market and economy (as it did in 2008).

"But the SEC will have to get involved," he concluded. "It will have no choice but to send a signal to speculators."

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