Market Manipulation Is Like Pornography: You Know It When You See It

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In a 1964 decision, U.S. Supreme Court Justice Potter Stewart said he would not attempt to define hard-core pornography, and “perhaps I could never succeed in intelligibly doing so.” He famously added, “But I know it when I see it.”  It’s kind of like that with market manipulation: What’s legal and what’s illegal is in the eye of the beholder. That will make it hard for the Securities and Exchange Commission to bring cases against the people behind the spectacular short squeeze on GameStop Corp. shares.

“More than eighty years after federal law first addressed stock market manipulation, federal courts remain fractured by disagreement and confusion about manipulation law's most foundational questions,” Merritt Fox of Columbia University Law School, Lawrence Glosten of Columbia University Business School, and Gabriel Rauterberg of the University of Michigan Law School wrote in 2018 in an article in the Yale Journal on Regulation.

“Manipulation,” the scholars wrote, “may be the most controversial concept in securities law.” The legal system overlooks some acts it should catch and catches some acts it should overlook, they wrote: It is “both under-inclusive and overinclusive in comparison to whatever is the ideal baseline.”

However legally muddled things were in 2018, they’re more muddled now. In the pump-and-dump schemes of old, it took a concerted effort to ignite a rally in a company’s shares, such as strategic buying of a big percentage of a company’s outstanding stock. Now, a few well-chosen words could be enough, thanks to the amplifying power of Reddit message boards and the democratization of investing through zero-commission brokerage firms like Robinhood Markets Inc.

With thousands or millions of newly empowered players ready to pounce on the latest trading idea, the tiniest of actions can trigger an outsized reaction, the same way shooting “Boo” at the top of a mountain can unleash an avalanche. “Technology has accelerated the speed with which information is disseminated through the markets. Someone says on a forum that they’re going to buy. You think, ‘There’s going to be a race here; I should buy as well,’” says Columbia Law School Professor Joshua Mitts. Within seconds, the stock soars.

Then the question becomes: Was that initial action illegal? Can the person who shouted “Boo” be blamed for the devastation at the bottom of the slope? “People can’t be responsible for others’ actions that are completely outside the realm of the foreseeable consequences of their behavior,” says Mitts. “We don’t want a world where I can be held liable civilly or criminally for exuberant behavior that results from something I said.”

Sometimes, though, the people who got the rally going really are culpable. The term of art is “momentum ignition.” An easy case is if they made false statements about the stock or about their own positions—say, they were selling when they claimed to be buying. A slightly harder-to-prove case is if they bought shares strategically with the intent of driving them higher. Or they told other market participants that the stock would move because of something they said or did. Some people on the Reddit message boards may have incriminated themselves by doing that—just as some of the clods who invaded the Capitol on Jan. 6 incriminated themselves by posting live video.

The differences between the storming of the Capitol and the GameStop craziness are vast. One was violent insurrection; the other is securities fraud at worst and a justified attack on powerful short-sellers at best. Still, one parallel is the question of incitement. Donald Trump never told his followers to smash windows, break down doors, attack officers, and roam the halls of the Capitol in search of members of Congress, but his critics say his language at the rally that day was at least partially responsible for their behavior. Absolutely not, his defenders reply. Likewise, the SEC will be parsing the language of the Redditors for statements that crossed the line into illegal manipulation—taking into account the mindset of the audience for those words. 

“It’s a bright line in legal principle. The proof problem can be difficult,” says Thomas Gorman, a partner in the law firm of Dorsey & Whitney who worked for the SEC early in his career. Manipulation is easier to prove when it’s done by a ring of sizable players than when it’s highly decentralized. “It’s not an easy case. It’s like the Lilliputians ganging up on Gulliver,” says Maurice Stucke of the University of Tennessee College of Law.

The Lilliputians may learn from this experience to choose their words and actions carefully in the future, so they get the desired result without crossing any lines. In the future, a statement as innocent as “I’m buying” could trigger a cascade. That would be hard to prosecute, given the First Amendment’s protection of free speech.

So the game will continue. “Everybody who engages in this has an idea what results are aimed for and has at least a vague idea of how such results are achieved,” Volker Nissen of Germany’s Ilmenau University of Technology writes in an email. “For me, this has characteristics of a battle. Hedge funds with their machinery on the one side, and the crowd of young investors on the other side.”

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