Retail investors storm Wall Street and Trump goes down in history as the heavy weight champion of getting impeached. Also, I am not a cat.

Welcome to another edition of Legalish.

HIT. THAT. SUBSCRIBE. BUTTON. Hit it like a wild pack of Redditors hit Melvin Capital the other week.

First, some Legalish news: Legalish secured its first ever sponsor, M&T Bank. They developed a service called Nota. If you’re an attorney you’re probably painfully aware that one of the only things that could put your license to practice in peril are mistakes involving your client trust account. You can do drugs, rack up DUIs, or run naked down the street, and maybe get a suspension from the bar (obviously, don’t do these things, either). But if so much as one penny is missing from your trust account, your days are numbered. Nota helps attorneys manage IOLTA accounts. Take it for a spin by tapping the picture below or clicking this text.

And now to ruin my relationship with my first and only sponsor! This Legalish kicks off with the French Revolution of Finance. There were hordes of peasant reddit investors at the gates and they rolled out the guillotine for the hedge funds—or did they? We’ll talk about democratized investing and then give a brief impeachment update because it’s kind of hard to ignore the former President’s title as heavy weight champion of getting impeached.

Also, I am not a cat.

The French Revolution of Finance

The other week Reddit’s Wall Street Bets community made some serious waves. And if you’re an early subscriber to Legalish this group is already on your radar because I wrote a little about them here. I’m one of Reddit’s moderators for some of the largest communities. Following the zeitgeisty whims of Redditors has been a hobby of mine for years. And /r/wallstreetbets has been no exception. Full disclosure: I owned some shares in GameStop very briefly and then I yeeted myself from the rollercoaster because, in the disparaging words of Wall Street Bets users, I have paper hands. I am also not a moderator of Wall Street Bets but I do know quite a bit about how Reddit works.

I think there’s two big takeaways from the Wall Street Bets assault on Wall Street. 1) The impact retail traders from Reddit had on GameStop was significant and interesting due to the mechanics of retail running up against a stock that had been heavily shorted. 2) The motivations of retail investors acting as a group are fascinating. Namely, what got them together and what social reasons motivated them to throw money at GameStop?

The Peasants are at the Gates and they have a Financial Guillotine.

The denizens of Wall Street Bets went toe to toe with a multibillion-dollar hedge fund, Melvin Capital, and delivered a blackeye to one traditional Wall Street investor in the form of a squeeze on GameStop. This resulted in a 53% loss to Melvin Capital who had a massive short interest in GameStop.

What’s shorting a stock mean? It means that Melvin Capital bet that the price of GameStop would fall. These bets can be elaborate but the simple explanation is that an investor opens a position by borrowing a share of stock at a certain price. They bet that the price of the stock is going to fall. If the price falls then the investor can return the borrowed share and pocket the difference in the borrowed price from the price that it fell to. The risk to the investor is that the price could rise or not fall below a certain threshold and then the investor has to buy the underlying share at the high price.

The short interest in GameStop was, as we now know, higher than economically warranted. Despite obvious struggles with a covid economy, GameStop, a brick-and-mortar business that sells videogames and related devices out of malls, was relatively healthy, even if on a trajectory of decline. But economic reasons for investing are kind of window dressing on what hedge funds sometimes do. In this case, Melvin Capital and other investors had shorted GameStop shares a lot. They had shorted the stock, then taken their borrowed shares and lent those fictional shares out which resulted in more shares short than actually existed to freely trade. It seems like the kind of thing that should raise red flags at the SEC. And, presumably, this aggressive short strategy would drive the price down to 0 or near 0, at which point the short pays off. In the event of bankruptcy there’s a windfall for the short interest because the difference is the value of the borrowed share and 0.

This is also a risky strategy. If a bunch of retail investors see a company with a low stock price that they believe is otherwise healthy, they might view it as a bargain. In other words, they might like the stock. Especially if there’s some underlying economic or nostalgic reasons to jump into that stock. If enough of them pile into it, the price goes up and then the shorts are forced to cover by purchasing the underlying shares. Which is why Melvin Capital lost billions of dollars.

Melvin Capital built the financial guillotine. They just didn’t think it would be used against them.

Pictured: Reddit investors armed with Robinhood accounts storming Melvin Capital.

Melvin should have seen this coming.

The squeeze on GameStop is less interesting for the short rollercoaster ride that happened for that particular stock than it is for the power of retail investors and their motives. A bunch of people trading stocks from their phone rattled traditional Wall Street so bad that the Nasdaq CEO contemplated shutting down trading so investors could recalibrate their positions.

But this also isn’t the first and certainly won’t be the end of retail’s influence in the market. Hertz, the rental car company, announced bankruptcy last year and the stock price surged 825 percent. That’s the exact opposite of what you’d expect to happen when a company announces bankruptcy. But retail investors armed with mostly Robinhood accounts saw value in the cheap stock. And who cares if they’re going bankrupt if between the announcement and whatever happens in court the price goes from 2 dollars to 5 dollars? Retail investors move in the way Internet groups move and assign value based on whatever the group has decided is valuable.

Prior to the bankruptcy filing, roughly 43,000 Robinhood accounts owned shares of Hertz. That number has nearly doubled to 73,000 as of Friday.

Citron Research, a company that releases summaries and recommendations for market moves warned retail investors against buying into GameStop. There were, in Citron’s view, economic reasons not to invest. But this kind of press release was seen by the Wall Street Bets community as a personal challenge to retail traders. If anything, it made the enthusiasm for the stock shoot up. From the sentiment on Wall Street Bets, Citron had economic reasons to be short on the stock, and there was blood in the water from the public information about the short interest in GameStop. And part of that sentiment was based on a hangover from 2008.

If you graduated college in 2008 (like me!) you faced a pretty bleak job market. You probably also noticed that major institutions got bailed out of their bad choices while average Americans had their retirements and housing situations destroyed. There was a perception of no consequences for Wall Street playing fast and loose with dubious securities while a lot of finger pointing and rhetoric attacked consumers for taking on housing they couldn’t afford. Wall Street gets massive financial bailouts. Normal people felt like they got a flippant and callous, “have you tried to stop being poor?”

So retail had a perfect storm in the case of GameStop. They had a mutual and amusing non-traditional interest in finance that brought them together. And they finally had an opportunity to retaliate against an institution they perceive as a modern robber baron. After all, from the perspective of Wall Street Bets users, Melvin Capital was effectively manipulating the value of a stock and maybe even putting that company and the jobs it supplies to normal people in peril because they wanted to loot it.

The one thing that did seem to slow interest in GameStop were restrictions on trading from Robinhood. Robinhood prevented trading completely on GameStop for a brief period. Then opened it up at limiting ownership to a handful of shares. The price almost immediately fell. My experience with users on Reddit is that they generally won’t switch what platform they’re on. And switching brokerages is pretty onerous. So one thing that may have stopped a truly wild run up on the stock was probably Robinhood itself. 

This account is, of course, the prevailing community wisdom of what happened with GameStop. As investigative bodies investigate—as they do—we’re going to learn more. Obviously, now, a lot of those same retail investors that were buying GameStop at $300/share lost money. Some, probably a lot of money.

What should the Security and Exchange Commission do? What’s the future hold for retail investors?

The SEC is a quasi-judicial quasi-legislative body that also has some executive powers. It is a weird thing in our system of separated powers to control all three of those functions. This means it has the ability to create rules, adjudicate them, and enforce them to preserve the integrity of the market. 

The biggest red flag that I can identify is that a stock could be shorted with more borrowed shares than the number of outstanding freely tradable shares existing. I don’t believe that’s supposed to be able to happen. In fact, market regulators have gone well out of their way historically to try and regulate short selling where institutional lenders orchestrate Bear Raids to tank a stock and profit off the short interest.  

In the event these massive short interests in this case are found to be part of a scheme of illegal market manipulation, the SEC should probably promulgate new rules to stop that because that scheme probably would not have been uncovered and punishable were it not for the squeeze. Even if it isn’t part of a scheme of illegal market manipulation, regulators should look carefully because these conditions can lead to some crazy market volatility, and hedge funds can’t be trusted to avoid bets that underestimate the likelihood of unlikely-but-economically-devastating events.

Unfortunately, I don’t have a crystal ball so I can’t tell you how this all plays out. Hopefully we’ll get some sort of conclusion in the next year or so.

I do believe there is a permanent shift in how people are investing. A certain class of people will always have their 401K and retirement accounts but there’s a glut of people who don’t have those choices set up or available and want to participate in the market. Thumb trading on a smart phone gives them access and in the Internet era you can learn as much or as little as you want about trading and different securities. These people shouldn’t be boxed out of participating merely because they might lose their shirt on some bad bets. If anything, they’ve proven that they can compete and outperform at least one multibillion dollar hedge fund—at least for a week or so until it all goes belly up.

Congress is holding hearings this Thursday regarding Wall Street Bets including testimony from Reddit user deepfuckingvalue who was the tip of the spear of reddit’s GameStop interest. Be sure to tune in for it.

Donald Trump: Responsible for half of all presidential impeachments. Gets acquitted by the Senate

Donald Trump is now the heavy weight champion of getting impeached. And he’s been acquitted twice now, this time 57-43 in favor of conviction with 7 members of his own party voting to convict him. That’s more votes from his own party voting for conviction than either Johnson, Clinton, or his first impeachment. This is quite a rebuke from his own party.

For anyone paying attention the result was a sad condemnation of the current state of the GOP. It’s important to keep in mind that while the Senate trial is called a “trial” and uses the term “conviction” it’s as much a legal process as it is a political one. Courts typically use these terms in connection with statutory crimes, while the Senate trial uses these legal terms in connection with political crimes—or “high crimes”—that don’t need to be based on violation of a criminal statute.

Impeachment and conviction isn’t reserved exclusively for presidents—it applies to all civil officers of the United States. Congress has collectively decided to yeet people out of their jobs before. In an early case, John Pickering, a federal judge, showed signs of mental deterioration, and after some controversial rulings the House brought impeachment related to drunkenness in office. He was ultimately voted off the island.

“High crimes and misdemeanors,” as the founders viewed the term, meant abuses of the office someone holds. (Federalist 65) While those offenses could overlap with statutory crimes—that is, conduct that Congress passes a law to prohibit by threat of criminal punishment—the term “high crimes and misdemeanors” is much broader. Congress effectively decides, on a case-by-case basis, whether proven conduct amounts to a political “high crime.” This term of art is brought over from the British parliamentary system, and the founders had a few hundred years of precedent to work from on what the impeachment process and standards looked like.

So how does Congress go from sacking a drunk judge to struggling over whether to convict a President that intentionally fomented an insurrection against the US Government?

If you’re a future historian you’re probably going to look first at what the House Managers did. Because surely they must have showed up as drunk as Judge Pickering to lose a case that strong.

And if you’re the future historian going through this case you’d probably think, “wow, this record is baffling.” First, the trial opened with a simple vote on whether Congress could convict a President that left office already. There is no “you can’t fire me because I quit” mechanism in the Constitution. And the Senate also clearly voted that way.

The House Managers proceeded to put together a strong case with a powerful evidentiary record where everyone in the Senate is a witness to what happened. My only criticism of the way the House Managers ran their case is that they won a vote to call witnesses then decided against it. It certainly would have helped build out the record and I don’t think there would have been a significant harm in deposing people. Reasonable minds can differ on this: ultimately, it is a question of where and when Congress will investigate this—in an impeachment setting, or under the more common select committee inquiry. Daniel Goldman, one of the impeachment attorneys from the first impeachment of Trump, has a different outlook on it. In sum though, the House Managers put together a strong case with a strong evidentiary record and presented it to a room full of witnesses.

The defense, on the other hand, kicked off with a rambling opening statement that at times seemed to invite conviction. Even Allen Dershowitz, Trump’s previous attorney for his last Senate trial, was confused at Castor’s opening statement saying, “There is no argument - I have no idea what he is doing.” 

To make things even more confusing to our future historians we also have a situation where the Senate as a whole voted that the trial itself is constitutional, which should have put that issue to rest. Democrats and Republicans voted in agreement on that issue. Yet, on the matter of conviction, 43 Republican Senators decided that vote didn’t count and that they disagreed with the constitutionality of the process.

Like I mentioned previously, impeachment and conviction are political processes. Despite a considerable number of Senate Republicans defecting it wasn’t enough to hit the Constitutionally mandated 2/3rds mark. And they were able to hang their hat on, “well, this doesn’t square with the Constitution” thing because they can frame their vote however they want. They’re not beholden to each other on the initial vote on that question. So, while the trial itself is constitutional Trump is acquitted because 43 Senators think acquitting based on the constitutionality of the process is politically easier to do. Sure, they were all almost murdered in horrific public fashion, but at least now they won’t get primaried.

But if a President can’t be convicted for an armed insurrection against the United States then pretty much nothing in this political climate can secure a conviction. Future abuses of executive power are virtually guaranteed in these conditions: there is no real check on the President at this point. In other words, unless we change something, there’s a very good chance our attempted self-coup is a harbinger of a successful self-coup—a how-to manual, a training exercise.

Let’s not end the newsletter on that sad note though.

I’m not a Cat.

In case you missed it here’s a lawyer showing up to a Zoom hearing with a cat filter on. I think my favorite part is where he tells the judge he’s ready to proceed.

LYNCH LLP

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