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Rekenthaler Report

Should the SEC Expand its Scope?

Rethinking 90-year-old regulations.

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Pump and Dump

The brokerage firm Boiler Room & Partners spends $5 million to buy 20 million shares of an obscure company, Mars Exploration. It instructs its brokers to call the firm’s customers, misinforming them that Elon Musk has been buying Mars stock. Enticed by this “news,” Boiler Room’s clients purchase 10 million shares of the company, at an average price of 60 cents per share. Boiler Room recoups $6 million of its $5 million investment, with 10 million shares still in hand.

Boiler Room then unloads its remaining 10 million shares. The trade pushes the price of Mars' stock back down from whence it came, with Boiler Room receiving an average of 40 cents per share for its sale. When added to the previous $6 million, this additional $4 million earns Boiler Room a 100% return on its Mars Exploration trade, within a few short weeks. Nice work if you can get it!

Regrettably for those with a nose for profit and lax consciences, this tactic, termed “pump and dump,” is illegal, courtesy of the Securities Act of 1933 and the Securities Exchange Act of 1934. After witnessing the damage that occurred when everyday investors lost confidence in the stock market, due to institutional manipulation, Congress was determined to prevent further incidents. The new regulations weren’t motivated solely by morality; they also were good business.

For similar reasons, portfolio managers can’t exaggerate the prospects of the companies that their funds hold, with the intent of increasing the price of those shares. Nor can they join with other institutional investors to promote their long positions (or denigrate the companies that they short). The SEC’s task is to ensure that the public markets are “safe and orderly.” Overhyped stocks aren’t safe, nor is their rise and fall orderly. The SEC was created to prevent such conduct.

Considering Main Street

Which leads to today’s question: What about social media investors? The SEC traditionally has viewed its role as protecting Main Street from Wall Street. This approach is logical, because operating individually, Main Street investors pose no threat. To be sure, the actions of everyday buyers can disrupt the marketplace, by being either unduly optimistic or overly bearish, but the SEC does not regulate the collective effect of independent decisions. Nor should it.

However, social media investors do not work alone. Many openly encourage other readers to buy securities that they already own. Often, their blandishments are based on incontrovertible facts, such as a company’s growth in earnings or new product launch. But inevitably, they sometimes also consist merely of rumors, or wishful thinking, or (most ominously) the suggestion that if enough people buy the stock, its price inevitably will rise. Were such an argument advanced behind closed doors, by institutions, that would be called “collusion.”

That such activity occurs instead openly, among individuals rather than institutions, strikes me as a difference without distinction. Spreading false information about an investment is unethical no matter who the shareholder happens to be. So, too, is coordinating with others in the hopes of altering a security’s price. Historically, the SEC has not ignored such actions not because they were acceptable, but because they were immaterial. Now they matter.

That is, social media discussions can directly and powerfully violate the SEC’s directive. That GameStop’s (GME) share price opened this year at $19, peaked at $480 later in January, and is at $162 currently, without significant changes in its business results (GameStop has stabilized its revenue, but continues to burn cash and cycle through chief executive officers) is, to repeat an earlier phrase, neither safe nor orderly. If the U.S. stock market regularly acted like that, it would indeed be a “casino,” as alleged by its critics. Only gamblers would benefit from that.

Counterarguments

Potential objections to the SEC expanding its mandate:

1) Don’t punish individual investors for leveling the playing field.

The argument: Wall Street has preyed upon Main Street since New York was a Dutch colony. Now that everyday investors can even the score--as GameStop’s buyers did to some hedge funds--it would be unfair to deny them their chance.

My response: Justice is a side issue. The SEC exists to ensure the public good of healthy, smoothly functioning markets. Besides, it’s not as if the commission ever sanctioned bad behavior. It might have lacked the resources to prevent Wall Street’s misdeeds, or perhaps even the willpower, but that was never its directive.

2) The SEC shouldn’t be prosecuting free speech.

The argument: The government has no business overseeing personal conversations. It should not be monitoring and regulating social media.

My response: It already is. If institutional investors and/or corporate insiders make fraudulent statements on social media, they are just as liable as if they were to do so through phone calls or speeches. Illegal is illegal.

3) The task is impossible.

The argument: It’s one thing to monitor a limited number of institutions, along with the executives of several thousand publicly traded companies. It’s quite another to attempt to oversee the discussions of everybody who directly holds equity shares (as opposed to through funds). The job can’t be done.

My response: True, the SEC’s reach would exceed its grasp. But that should not prevent it from trying. After all, the SEC cannot possibly track the activities of all friends and relatives of corporate insiders. That does not prevent the commission from prosecuting insider-trading violations, should it encounter them.

Wrapping Up

This column is not a call to action. To date, stock-market disruptions caused by social media have been the exception, not the rule. Perhaps that will continue. Or, perhaps, the SEC will find better reasons than the ones I have offered for not increasing its purview. But I do think the time is right for the SEC to re-evaluate its duties. Over the past 90 years, more than a few things have changed.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.