Expressive Trading and Markets
The phenomenon of social-media-driven trading (SMD trading) entered the public consciousness earlier this year when GameStop’s stock price was driven up two orders of magnitude by a “hivemind” of individual investors coordinating their actions via social media. Some believe that GameStop’s price is artificially high and is destined to fall. Yet the stock prices of GameStop, and other prominent SMD trading targets like AMC Entertainment, continue to remain well above historical levels.
As we describe in our forthcoming article, Social Media, Securities Markets, and the Phenomenon of Expressive Trading, much SMD trading was driven by profit motives. But a meaningful part of the rise has been a result of expressive trading—a subset of SMD trading—in which investors engage for non-profit-seeking reasons like social or political activism, or aesthetic reasons like a nostalgia play. To date, expressive trading has only benefited issuers by raising their stock prices. There is nothing, however, to prevent these traders from employing similar methods for driving a target’s stock price down (e.g., to extort certain behaviors from issuers).
At least for now, stock prices raised by SMD trading have been sticky and appear at least moderately sustainable. The expressive aspect, which unites the traders under a common banner, is likely a reason that dramatic price increases resulting from profit-seeking SMD trading have persisted. Without a nonfinancial motivation to hold the group together, its members would be expected to defect and take profits.
In GameStop’s case, hedge funds had taken large short positions in its stock, which could have forced the company into liquidation. In response, SMD traders attempted a short squeeze. They succeeded in saving the company, raising the values of their portfolios, and forcing some of the hedge funds out of business.
As SMD trading drove their stock prices higher, it provided an opportunity for GameStop and AMC, which had also faced strong short-selling pressures, to raise additional capital. AMC took that opportunity. GameStop initially did not, fearing reprisal from the Securities and Exchange Commission (SEC), but has since raised over $1 billion in a follow-on offering.
Given that SMD trading appears not to be a mere passing fad, issuers and their compliance departments need to be prepared to respond when targeted by SMD trading. A question that might arise is whether and when SMD-trading-targeted issuers, and their insiders, may trade in their firms’ shares without running afoul of insider trading laws.
Current Insider Trading Law
Insider trading liability in the United States has never been expressly defined by statute or rule. The principal statutory authority for insider trading liability is Section 10(b) of the Securities Exchange Act of 1934, which prohibits the employment of “any manipulative or deceptive device or contrivance” in “connection with the purchase or sale, of any security.” While § 10(b) functions as a “catch-all” provision, in Chiarella v. United States, the Supreme Court clarified that “what it catches must be fraud.” An insider’s trading is only fraudulent if it is based on an information advantage that the insider has a duty to disclose. The courts recognize such a duty to disclose under two theories, the “classical theory” and the “misappropriation theory.”
Insider trading liability arises under the classical theory when the issuer, its employee, or an affiliate seeks to benefit from trading (or tipping others who trade) that firm’s shares based on material nonpublic information. In such cases, the insider (or constructive insider) violates a fiduciary or other similar duty of trust and confidence by failing to disclose the information to the firm’s shareholder (or prospective shareholder) on the other side of the trade.
Insider trading liability arises under the misappropriation theory when one misappropriates material nonpublic information and then trades on it without first disclosing the intent to trade to the source of the information. The “misappropriation theorypremises liability on a fiduciary-turned-trader’s violation of a duty to disclose to those who entrusted him or her with access to the confidential information” by cheating them out of “the exclusive use of that information.”
Where issuers or their insiders contemplate trading company shares while the target of expressive trading, the principal issue appears to be whether the information on the basis of which they are trading is material or nonpublic. Information is “material” for purposes of insider trading liability if “there is a substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision, and there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”
Courts and the S.E.C. have developed two tests for determining when information is “nonpublic.” Under the “dissemination and absorption” test, information must first be “disseminated in a manner calculated to reach the securities marketplace in general through recognized channels of distribution.” Information is disseminated to reach the market “in general” if it is not directed to any one person or group. Recognized channels of distribution would include the Dow Jones Broad Tape or national publications such as the Wall Street Journal. Even if distributed, however, information is not regarded as public until it has been “absorbed” by the investing public, meaning that enough time must have passed for it to be “readily translatable into investment action.” Depending on the circumstances, absorption may be a matter of minutes or days.
Alternatively, under the Efficient Capital Market Hypothesis (ECMH) test, information may be regarded as public even if it has not been generally distributed. Under this approach, the “issue is not the number of people who possess it but whether [trading in an efficient market] has caused the information to be fully impounded in the price of the particular stock.” The logic behind the ECMH test is that information cannot be misused for trading profits after it is fully reflected in the price of the stock.
What’s an Expressive Trading Target to Do?
If an issuer finds itself a target of expressive trading, what options are available to the issuer and its insiders? If the price is driven up, can the corporation or its insiders sell? If the price is driven down, can they buy?
The following four scenarios help bring these questions into focus:
- Scenario 1: XYZ Corporation’s stock price has been driven up as a result of a well-publicized SMD short squeeze attempt. Based on this information, XYZ and some of its insiders issue/sell XYZ shares.
- Scenario 2: XYZ’s stock price has been driven down by a well-publicized SMD short-sale attack, commenced because XYZ wouldn’t commit to installing solar panels on company property. In response, XYZ and some of its insiders buy XYZ shares.
- Scenario 3: XYZ secretly learns that a group claiming to have numbers to engage in an SMD run on XYZ stock plans to drive up the stock price in an attempt to rescue the company from impending bankruptcy. XYZ does not disclose this information. Based on this information, XYZ and some of its insiders buy XYZ shares.
In scenario 1, both XYZ and the insiders are privy to information indicating that the stock is overvalued. Trading on that information would be illegal under Rule 10b-5 if it is material and nonpublic. But the nature of SMD trading virtually guarantees that the public also knows that the stock is overvalued, at least according to traditional valuation metrics—calling into question both its materiality and publicity under Rule 10b-5.
If XYZ’s stock price is multiple orders of magnitude higher than that dictated by, say, analysts’ public valuations, it is a stretch to say that a reasonable shareholder would “consider . . . important” an insider’s knowledge pertaining to XYZ’s fundamentals. In other words, the gap between the market and “true” value is so large that the inside information would be unlikely to change the “total mix” of information on which average investors would base trading decisions.
Similarly, news that SMD activity has pushed a stock’s price orders of magnitude above its prior trading levels would certainly be disseminated by recognized channels of distribution, as evidenced by the media frenzy with GameStop and AMC’s rise. Assuming issuers or its insiders trade after this attention has been absorbed by the investing public, the publicity requirement should also be satisfied. And by its nature, the potential effect of the inside information is necessarily subsumed within the effect of the surge caused by SMD trading under the ECMH test. One question remains: how “inflated” does the stock price have to be before these conclusions concerning materiality and publicity hold—20%? 50%? 300%?
In scenario 2, XYZ and its insiders would also be tiptoeing in and around insider trading territory. Because the public knows about the short-selling and the reasons driving it, much of the information that XYZ and insiders would rely on in making their purchases is immaterial and public for the reasons described in discussing Scenario 1. From a policy perspective, the argument against insider trading liability here is stronger, at least for the issuer, because, unlike Scenario 1, the trading is done for defensive purposes, rather than for profit. Consider, however, that if all parties to the extortion attempt stayed quiet, as they do in Scenario 3, SEC or Department of Justice action would be much more likely, even though profit was not the motivation. And the SEC has, on occasion, pursued liability for others—like Raymond Dirks in his attempt to expose fraud—who were motivated at least in part by socially beneficial goals.
Scenario 3 differs from the previous ones in two important ways. First, the SMD trading has not yet taken place. Second, the news of the imminent SMD trading remains undisclosed. Here, the trading is motivated by information of the impending stock-price surge. This information would be considered important by the reasonable investor and would change the total mix of information available in the market. Similarly, the information has been neither disseminated nor impounded in the stock price and would therefore qualify as nonpublic. Moreover, there is no countervailing defensive justification for the issuer’s trading as there is in Scenario 2.
John P. Anderson is J. Will Young Professor of Law at Mississippi College, School of Law
Jeremy Kidd is an Associate Professor of Law at Drake University Law School
George A. Mocsary is a Professor of Law at the University of Wyoming College of Law
This post builds on their paper, “Social Media, Securities Markets, and the Phenomenon of Expressive Trading”, available on SSRN.