• Benjamin Bain (Bloomberg)

SEC Says It’s Investigating Stock Mania for Potential Misconduct

The U.S. Securities and Exchange Commission, facing intense pressure to respond to the recent mania in the stock market, said it’s seeking to identify potential misconduct and will scrutinize brokerages’ decisions to halt buying that triggered a retail-investor revolt.


The SEC warned traders about engaging in illegal schemes to drive up share prices and said it was working with other regulators, stock exchanges and federal agencies to “identify and pursue potential wrongdoing,” according to a statement released Friday by acting chair Allison Herren Lee and the agency’s commissioners.


The SEC leadership added that the agency “will closely review actions taken by regulated entities that may disadvantage investors or otherwise unduly inhibit their ability to trade certain securities.”


The remarks were the most aggressive yet from Wall Street’s top regulator following a week-long frenzy that has seen small-time investors harness social media to drive up GameStop Corp., AMC Entertainment Holdings Inc. and other stocks, hedge funds get crushed by their short bets, and Robinhood Markets and other brokerages restrict trading in the inflated securities.


By Friday, restrictions had been lifted and the massive rally in GameStop and others was back on. The stock advanced 68% to $325 in New York trading.


Action Demanded


The tumult has shaken the finance industry and prompted demands for SEC action from both Democrats and Republicans on Capitol Hill. The outrage reached a fever pitch Thursday, with lawmakers expressing indignation that investors were prevented from adding to their bullish GameStop positions. Many said they suspected the move was done to help hedge funds, a claim that brokerages rejected.


SEC officials briefed congressional staffers Friday on the agency’s response to the frenzied trading, walking the aides through the types of fraud it’s on the lookout for and explaining rules that prohibit investors from making false statements to move stock prices, according to a person with knowledge of the matter who asked not to be named because the discussions were private. The SEC officials also explained Robinhood’s rationale for limiting trading in GameStop, the person said.


An SEC spokesman didn’t immediately respond to a request for comment.


Senator Elizabeth Warren, one of Wall Street’s loudest critics, pressured the SEC on Friday to get to the bottom of the wild trading. In a letter to Lee, the Massachusetts Democrat said she’s concerned that the “casino-like swings” in GameStop and other companies are diminishing confidence in the stock market.


Warren noted that the recent surge wasn’t based on any changes in the company’s fundamentals, but rather by “anonymous traders on the Reddit forum.” In addition to repeating some of her longstanding criticism of private equity firms and hedge funds for “treating the stock market like a casino,” she also called on the SEC to examine whether securities rules were broken.


“The commission must review recent market activity affecting GameStop and other companies, and act to ensure that markets reflect real value, rather than the highly leveraged bets of wealthy traders or those who seek to inflict financial damage on those traders,” she said.


It’s not ideal that the SEC is grappling with the mayhem at a time when it lacks permanent leadership. Gary Gensler, who was a Commodity Futures Trading Commission chairman during the Obama administration and is also a former Goldman Sachs Group Inc. partner, is President Joe Biden’s pick to take the reins at the SEC. But no hearings have been scheduled in the Senate to consider Gensler’s nomination. Lee was installed as acting head this month.


Robinhood’s Role


Robinhood has been at the center of much of the tumult, as it’s been the preferred platform to trade for the army of investors who’ve banded together on Reddit message boards to hype GameStop and AMC. Robinhood temporarily restricted the buying of those shares Thursday, infuriating many of its customers. It also sought more than $1 billion in additional cash after the stock market’s main clearing hub demanded large sums of collateral from brokerages.


The highly complex nature of stock markets and the lengthy process for writing new rules means any SEC regulatory changes are likely a ways off. Still, the agency has significant power to influence market behavior by opening investigations, fining or banning those accused of wrongdoing and using the bully pulpit to issue warnings -- as it did Friday.

In pursuing possible manipulation of stock prices, the SEC said it’s focus would be on protecting “retail investors.” It cautioned that market participants “should be careful to avoid” illicit schemes.


Some of the most common are “pump-and-dumps,” in which traders dump their shares after enticing others to buy at the inflated price. Still, such cases can be hard for the SEC to prove because they typically hinge on showing that investors knowingly spread false information to dupe others. And there’s no indication thus far that the Reddit crowd sought to unload their holdings at the highs.


‘Momentum Trading’


“There’s no prohibition against momentum trading,” said Brad Bennett, a former enforcement director of the Financial Industry Regulatory Authority, the brokerage watchdog. “It’s the tulip bubble meets Twitter.”


Donald Langevoort, a Georgetown Law professor, said the SEC will have to reach a conclusion as to whether the wild trading was triggered by misconduct.

“With all the political fallout, the SEC must do something about this,” he said. “There’s blood on the floor.”


Sherrod Brown, the incoming chairman of the Senate Banking Committee, said he’d hold a hearing on the state of the stock market. In a Thursday statement, the Ohio Democrat said “it’s time for the SEC and Congress to make the economy work for everyone, not just Wall Street.” Representative Maxine Waters, who chairs the House Financial Services Committee, has also pledged to hold a hearing, saying in a Thursday statement that “hedge funds have a long history of predatory conduct.”


Deeper Look


Meanwhile, some lawmakers called for a deeper look into factors that have contributed to the dramatic rise in retail investing -- a boom that has been fueled by popular online platforms like Robinhood’s offering free trades.


Representative Rohit Khanna, a California Democrat, said on Twitter Friday that Robinhood Chief Executive Officer Vladimir Tenev must disclose whether he discussed the move to restrict trading with Citadel Securities, which pays Robinhood to execute a chunk of its clients’ orders. The arrangement is key to how Robinhood makes money since it doesn’t charge its customers commissions.


Citadel Securities had no role in brokerages suspending or limiting trading, a spokesperson said. In addition, the Citadel hedge fund wasn’t involved in any way in the trading restrictions, the spokesperson added. Billionaire Ken Griffin controls both firms.


Alan Grujic, chief executive officer of All of Us Financial, said his online trading platform also temporarily stopped accepting buy orders Thursday for several stocks at the request of its clearing firm. Grujic said he didn’t agree with the request, although he’s sure there were operational reasons behind it.


“There’s an element of protecting customers, but I have a concern that their inability to buy might unfairly weaken the choices that customers have,” he said Thursday. “I worry when decisions are made that dis-empower a particular group.”


As it seeks to get ahead of the wild market swings, the SEC is turning to the public for help. In its Friday statement, the regulator issued a reminder that market participants can submit tips and complaints to the agency.

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© 2021 by Mike Burbie, a Preuss Media LLC affiliate.