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SHORT SQUEEZE& OPEN TRADING DAMAGES Lost Investment Opportunities, Out of Pocket Losses, Manipulation, or Disgorgement of Cost Savings?

PREPARED BY JULLAVUT KITTIAKARASAKUN, PH.D, SEAN T. MALONE, PH.D. & MAURICIO VIDAURRE, M.S. SQUEEZE TRADING DAMAGES

ConContents- tents

1 Introduction 1 Recounting the Events Leading to Litigation 5 Difficulties Measuring Damages 5 Alternative Methods to Estimate Damages 10 Conclusion 11 About Us

The authors would like to extend their gratitude to Dr. John Wald for his valuable comments and insights on this paper. 01 | ANALYTIC FOCUS, LLC WHITE PAPER

Introduction

The market suffered more than ordinary tumult on January 28, 2021, due to the endeavors of several entities engaging in trading. These players include retail , -dealers, clearing houses, and investment funds. Each of these had their own set of incentives and were affected in different ways. This paper lays out what happened leading up to and on January 28 from the perspectives of these disparate groups.

Some or all of these stakeholders experienced losses. Naturally, the stakeholders want to recover those losses and have filed lawsuits that are in their nascent stages. The problem for parties embroiled in this litigation is understanding what happened and how this may lead to damages. After a summary of what happened, this paper addresses the process of measuring damages. The process suggested here builds on the impacts potentially experienced by each stakeholder.

Recounting the Events Leading to Litigation

Consider Melvin Capital, a hedge fund, which has held a short in GameStop stock since 2014. This fund believes that selling video games in physical stores is being overtaken by digital delivery. For this reason, it believes the share price of GameStop is higher than it should be. By maintaining a short position, a decrease in the stock price will create positive returns for Melvin Capital’s investors. One way to have a short exposure to GameStop is to sell borrowed shares.

To open a short stock position, one borrows shares of a stock and sells them to another . This creates an obligation to return the borrowed shares. If the short seller is correct in their anticipation and the price of the stock falls, they can buy shares from the market at a lower price than the price for which they sold them. The difference between the sale and purchase price is a measure of their profit. But, if the price of the stock SHORT SQUEEZE TRADING DAMAGES | 02

increases, the value of their obligation to return the borrowed shares increases. At some point, the short seller must close the position. They must buy the shares from the market and return the borrowed shares to the rightful owner, even if they must pay a higher price.

This highlights a key difference between a short stock position and a position (buying a share of stock). Short positions receive a credit when opening, but create an obligation of an uncertain value in the future. To make sure the trader has enough cash to meet the obligation, they must post “”. If the price of the stock being shorted rises, the trader may be subject to a margin call. A margin call requires the trader to deposit more funds to maintain the position. A dramatic price increase likely will create liquidity problems for the trader. This could force them to exit other investments or to cover their short position at a loss.

If there is a very large aggregate short position, where many or all short sellers face this possibility, a “short squeeze” may occur. When a large concentration of traders is shorting a stock, an increase in stock price can trigger a feedback loop to the detriment of all the short sellers. As some short sellers buy shares to cover their position and to prevent further losses (or as lent shares are recalled), they add to the demand for the stock. This places more upward pressure on the price. As the price continues to increase, more short sellers may follow suit as losses and strains on liquidity grow larger. A spiral of losses is created.

Savvy retail investors on social media noted the possibility for short squeezes in several . Some discussions by these commentators focused on a more fundamental bullish outlook for GameStop. Other discussions focused on sparking a short squeeze and benefitting from its impact.

Many investors use as their broker- dealer. Just after 5:00am ET on January 28, Robinhood received its daily collateral notice from NSCC (National 03 | ANALYTIC FOCUS, LLC WHITE PAPER

Securities Clearing Corp). The NSCC is a subsidiary of the DTCC (Depository Trust and Clearing Corp) and serves as a central counterparty for equity trading. The purpose of a central counterparty is to reduce counterparty risk.

Counterparty risk is the risk that a party on the other side of the stock trade will not deliver the securities or cash as agreed on the settlement date. To guarantee that each party (two ) will deliver the securities and cash on the settlement date, the central clearing party requires its members to post collateral. Since the settlement date for equities in the U.S. is on a t+2 convention (trades settle two business days after the trade date), the value of the securities due at settlement is uncertain as their value can fluctuate.

Thus, the collateral requirements for net unsettled positions is largely based on the security's price . The price for GameStop and other highly shorted stocks had been extremely volatile during the week leading up to January 28, justifying unprecedented deposit requirements from the NSCC. Beyond the charge based on volatility, Robinhood’s notice also included a $2.2 billion excessive capital premium charge. NSCC levies these charges when brokerages have deposit requirements greater than their excess net capital.

While NSCC later decided to waive the entire capital premium charge for all clearing members, Robinhood chose to place restrictions on purchases of several stocks. These restrictions would limit their unsettled positions in the stocks that were driving the extreme deposit requirements. Robinhood has since announced it has raised at least $3.4 billion to ensure that it can meet its deposit requirements in the future and avoid placing trading restrictions on its customers.

Robinhood was not the only broker-dealer who restricted trading on January 28. Other broker-dealers also had increasing deposit requirements. The NSCC aggregate collateral requirements increased by $7.5 SHORT SQUEEZE TRADING DAMAGES | 04

billion from January 27 to January 28.1 This would include increases for Robinhood as well as other broker-dealers named in short squeeze litigation such as TD Ameritrade, Ally, Charles Schwab, and others.

These restrictions took the customers of the brokerages by surprise. Those who believed the short squeeze thesis and wanted to purchase stock or call options could not. The skyrocketing prices only confirmed the beliefs of those who had already purchased shares. Many wished to buy more shares and more options. But, the brokers prevented them accessing the market for these transactions. From the traders' perspective, the brokerages held them back from profitable trading opportunities.

The restrictions on purchasing placed by these brokers also gave a special opportunity to short sellers. The anger and confusion of retail investors unable to buy restricted securities was highly publicized. Short sellers, already suffering from the increased prices, knew more demand existed for these stocks. However, brokerages placing trading restrictions were preventing this demand from entering the market. This allowed short sellers an opportunity to cover their positions at prices favorable to those if the restrictions had not existed. Some of these short sellers (or those with investment interests in them) include large hedge funds like Citadel, Point72, and Melvin Capital.2

Perceived potential relationships between hedge funds that would benefit from suppressed prices and these brokers have stoked theories of conspiracy. For example, the hedge fund company of Citadel and Citadel Securities both share the same founder and majority shareholder, Ken Griffin. Robinhood Financial LLC receives payment from Citadel Securities for routing their flow to them. This practice, known as payment for order flow, is key to Robinhood's business model and allows it to provide commission- free trades. The conspiracy theories allege brokerages placed restrictions on trading to suppress prices to protect short sellers at the expense of their customers.

[1] See the February 18 statement of Michael Bodson (DTCC) to the House Financial Services Committee and on January 29. [2] Melvin Capital claimed it closed its short positions on GameStop Corp. by January 27 (see Bloomberg News on 1/27). However, since short stock positions are not publicly disclosed, discovery will need to verify the short exposure of Melvin Capital and other funds at the time trading was restricted. 05 | ANALYTIC FOCUS, LLC WHITE PAPER

Difficulties Measuring Damages

Many retail investors who owned the restricted securities, and others who wished to purchase shares or call options, may have been damaged by these restrictions. There are several obvious difficulties in estimating damages for these two groups based on lost trading opportunities. First, while data from brokerages will identify owners of the restricted securities, an expert could not use this data to identify those who wished to purchase them but were unable to do so. Second, one would need to determine how many shares/ options each trader would have purchased (and at what times) in the absence of trading restrictions. Third, a damages expert also would need to estimate the prices the traders would have been willing to sell their shares for, if retail investors had been allowed to purchase them. Finally, the expert would need to opine on the market price of the shares, but-for the trading restrictions. Following traditional methods, it would be exceptionally difficult to estimate both the amount of damages and the investors who suffered damages.

Alternative Methods to Estimate Damages

These many challenges facing damages calculations based on lost trading opportunities likely seem insurmountable. To address these challenges, in this section three theories are presented that offer more tractable frameworks and methodologies for damages estimation.

1. Out of Pocket Losses: Because Robinhood’s and other brokers’ restrictions suppressed the market prices of the restricted stocks, investors who sold the shares and stock options during that time suffered losses from artificially low prices. These investors could be compensated for their losses.

By imposing a restriction on buy orders but not on sell orders, the brokerages artificially suppressed demand for the restricted stocks and distorted pricing dynamics. Before the restriction was imposed, short sellers had oversold the stocks. For example, the number of GameStop (GME) shares being sold short at that time was 136% of the shares available SHORT SQUEEZE TRADING DAMAGES | 06

in the market. Short sellers were obligated to buy back the shares or deposit more cash in order to maintain their short position. As retail investors continued to buy, short sellers now had to compete with retail investors for the limited shares available in the market. The price of GME shares skyrocketed. One can view the price increase as a result of the competition for the limited number of shares as a liquidity premium. Hence, the prices of the stocks have two components: fundamental value and liquidity premium.

For the restricted stocks, the liquidity premium component is volatile and depends largely on the level of competition and the number of shares short sellers had to buy back at that time. The more shares the short sellers needed to buy back, the higher the liquidity premium. Robinhood’s restriction constricted the liquidity premium as it temporarily suppressed the level of competition.

While the restriction was in place, many short sellers bought back the stocks at uncompetitive prices and unwound their short positions. As shown in Table 1 below, the number of shares short sellers would have to buy back decreased nearly two-thirds after the restriction was lifted, from 61.7 million mid-January to 21.4 million by the end of January. This allowed short sellers to reduce the number of shares that the short sellers needed to buy back. As the number of shares the short sellers needed to buy back had dramatically fallen (reduced demand), the value of the liquidity premium evaporated.

Table 1: Short Interest of GameStop SHORT % OF SHARES DATE INTEREST FLOAT 1/15/2021 61,782,730 136% 1/29/2021 21,409,004 47% 2/12/2021 16,468,038 36% 2/26/2021 14,200,138 31% 3/15/2021 10,187,324 22% 07 | ANALYTIC FOCUS, LLC WHITE PAPER

Note also that some sell orders on January 28 may have been triggered by the restriction. As mentioned earlier, the high values of the restricted stocks prior to the imposition of the restriction was due to their liquidity premium, which depended on the number of shares that short sellers would need to buy back. As the restriction was in the process of being imposed, astute investors would understand that short sellers would take this opportunity to unwind their short positions.

Hence, after the restriction was lifted, the liquidity premium was not as high as it had been. With this expectation, some investors would sell as soon as possible before the liquidity premium would fully evaporate. Additionally, as some investors rushed to sell their shares, stock prices would plummet triggering other investors who previously bought the shares on margin accounts to rapidly sell.3

Consequently, one theory of damages would suggest that any investors who sold the stocks when the restriction was imposed then suffered losses from having to sell their shares at suppressed prices. And because values of stock options are tied directly to the stock prices, investors who also sold their call options suffered losses from the lower options prices.

Thus, the first calculation of damages is that, for stocks and call options sold during the restriction, damages are the numbers of shares and option contracts sold multiplied by the difference between the actual sale price and what should have been the competitive price. This calculation is applied to stock and options contracts separately. The number of shares or option contracts sold during the restriction as well as the actual sale price could be obtained directly from public records. The competitive price is the only component to be estimated using time-series models.

Alternatively, one can derive a conservative measure for the competitive price based on financial theory. Recall that the prices of the restricted stocks were high because of the liquidity premium, which is a direct function of the number of shares short sellers needed to buy back. The first price after the restriction was lifted could be viewed as a competitive

[3] Traders who buy on margin accounts are required to maintain certain levels of deposit. And part of the deposit can be the purchased stocks. When the stock values decline, the deposit could fall below the required maintenance level, triggering a call for more cash deposit (known as “margin call”). Traders who cannot meet the margin call requirements are forced to sell the stocks at a loss. SHORT SQUEEZE TRADING DAMAGES | 08

price that reflected the level of short interest at that time. And since the level of short interest before the restriction was lifted was higher, the value of the stocks in the absence of the restriction must be also higher than the first price after the restriction was lifted to reflect higher liquidity premium. Thus, the first price after the restriction was lifted provides a lower bound for the competitive price.

For example, according to Yahoo Finance, the highest price of GME on January 28 was $483 and the lowest price was $112. Assume that average GME share price was around the midpoint, about $297. The opening price on January 29 was $380, a conservative competitive price. The difference between the approximate trade price ($297.62) and the competitive price ($379.71) is $82.08. Trading volume for GME on January 28 was 58.8 million shares. Assuming that only 10% of overall trading volumes are discretionary trades, this would give us an approximate lower bound of $483 million (= 58.8 x 10% x $82.08) for the damages due to GME shares sold.4

This figure is for the GME shares only. One can apply a similar calculation to GME stock options and other restricted stocks.

2. Short Seller Ill-Gotten Gain from : Some brokerages allegedly manipulated the share prices to help short sellers unwind their positions in a non-competitive environment.

As mentioned in the previous section, the trading restrictions placed by Robinhood and other brokerages allowed short sellers to unwind their short position in a non-competitive environment. Clearly, short sellers benefited from this restriction. And since stock trading is a zero-sum game, an alternative view for the damages calculation could be obtained from estimating how much the short sellers gained (or avoided losing) from this restriction.

From Table 1 on page 6, the number of shares for short sellers decreases from 61 million to 21 million within 10 trading days, an average of about 4 million shares per trading day.5 If short sellers could buy back 4 million shares

[4] https://www.cnbc.com/2017/06/13/death-of-the-human-investor-just-10-percent-of-trading-is-regular-stock-picking- jpmorgan-estimates.html [5] Bloomberg short sale data is available on a bi-monthly basis. Alternative short sale data source such as NYSE is available on a daily basis but requires subscription. 09 | ANALYTIC FOCUS, LLC WHITE PAPER

on January 28 at an average price of $297.62 rather than the competitive price of $379.71, they would have saved $328.3 million [=(379.71 – 297.62) * 4 million]. And since this ill-gotten gain occurred at the expense of some investors in the market, the alternative measure of damages is $328.3 million.

Again, this rough estimate for damages should be viewed as a conservative measure because the share price could be higher than the first price on January 29 if the restrictions were not in place. In addition, this figure has not accounted for the losses to option traders.

3. Disgorgement of Cost-of-Capital Savings: Broker- dealers placed trading restrictions because they were not adequately capitalized. Had the brokers raised additional equity investments for their companies, they could have provided normal access to markets for these securities. However, Robinhood and other brokers decided it was more efficient to breach their contracts, restricting market access. By doing this they profited from avoiding the expenses of raising this capital and the associated costs.

Poor risk management did not cause all brokerages to restrict their customers’ trading. For example, cash traders using Fidelity, Vanguard, or J.P. Morgan’s YouInvest experienced few issues trading securities like GameStop and AMC. A better capitalized Robinhood could have kept unrestricted access to all securities. Robinhood publicly admitted this.

“After Robinhood Securities paid the NSCC deposit requirement on January 28, Robinhood began discussions with our investors to raise new capital to ensure that we could meet future potential deposit requirements and thereby return to providing Robinhood customers unrestricted access to all securities on the platform. Over the course of approximately four days, we received commitments for approximately $3.4 billion from investors.” 6

[6] CEO of Robinhood, Vlad Tenev’s written testimony for the February 18 House of Representatives’ Committee on Financial Services hearing. SHORT SQUEEZE TRADING DAMAGES | 10

An additional $3.4 billion would have prevented these trading restrictions. Robinhood avoided the expenses of such financing when it chose to remain undercapitalized. Robinhood gained by risking the possibility that they may need to block their customers from trading opportunities in volatile markets. Disgorging these gains from brokers provides a third alternative or supplemental approach to damages calculations.

Conclusion

Understanding the roles and incentives of the various groups whose actions drove the volatility and trading restrictions on January 28 yields several approaches to damages, providing alternatives to lost trading opportunities. These alternative approaches include out of pocket losses for those who sold securities during the restrictions, ill-gotten gains from the manipulated share prices, and disgorgement of cost of capital savings. These alternative theories and methods may provide useful insights in the review of January 2021 Short Squeeze Trading. 11 | ANALYTIC FOCUS, LLC WHITE PAPER

QUI RENTUR, OMNIM QUAM RERCIA

ABOUT ANALYTIC FOCUS, LLC Analytic Focus, LLC is a quantitative consulting firm headquartered in San Antonio, TX with offices in Washington, D.C. and Birmingham, AL. We serve our clients with economic, financial and statistical analyses. For the last decade, Analytic Focus has provided support in approximately 150 lawsuits involving thousands of Residential Mortgage Backed Securities. Our team comprises Ph.D.'s and industry experts with decades of experience serving the banking, education, energy, finance, government, healthcare, housing, insurance, legal, retail and transportation industries. We analyze data and apply innovative methods to complex problems. Our experts have testified at trial, in hearings and in depositions for cases that involve financial dealings, deceptive sales practices, fraud, biostatistical measurement and environmental issues. Our underwriting team has re-underwritten a quarter of a million residential loans for litigation and they underwrite commercial loans for credit unions, banks and cities.

ABOUT JULLAVUT KITTIAKARASAKUN, PH.D Dr. Jullavut Kittiakarasakun is the Associate Director of Statistical Consulting at Analytic Focus, LLC. He has over a decade of expertise in managing and analyzing large data, extensive knowledge of statistical and econometric tools and applications, and skills in programming financial models, complex algorithms and simulations. Dr. Kittiakarasakun is also experienced in Monte Carlo Simulations, Risk Management, Regressions and Time Series Analyses, and programming languages such as SAS, STATA, R, C/C++, SQL, Eviews, Mathematica, Basic, COBOL, Visual Basic, and Microsoft Excel VBA. Dr. Kittiakarasakun has taught at multiple universities in areas of corporate finance, business finance, statistics, and investments. He has also served as a System Analyst and Programmer in Thailand, Turkey and Vietnam providing computer coding, inventory control systems, and advanced model development. He has been published in the Review of Applied Economics, Managerial Finance, Journal of Economics and Finance, International Review of Economics and Finance and the Review of Financial Economics journals on topics addressing the impact of exchange recognition and electronic advancements on securities trading, risk management of Asian stock portfolios, and behavior of closed-end mutual fund share prices. Dr. Kittiakarasakun is fluent in Thai and English. SHORT SQUEEZE TRADING DAMAGES | 12

ABOUT SEAN T. MALONE, PH.D. Sean T. Malone is a Senior Research Associate with Analytic Focus, LLC. Dr. Malone has a strong background in data analysis and econometrics. His research has dealt with developing new event study measures for volatility and measuring their performance using Monte Carlo Simulation methods, conducting fixed-income event studies, and developingQUI and RENTUR, analyzing OMNIM long/short equityQUAM factor RERCIA investment strategies. In addition, he has coded credit default swap pricing models and conducted other empirical analyses using regression analysis, time-series models, and other statistical tools. Dr. Malone has significant scripting experience in STATA, Python, and Microsoft Excel VBA. Prior to joining Analytic Focus, LLC, Dr. Malone taught undergraduate courses in business finance, investments, money and banking, and financial case studies at The University of exasT at San Antonio.

ABOUT MAURICIO VIDAURRE, M.S. IN FINANCE Mauricio Vidaurre is Vice President of Analytics at Analytic Focus, LLC. Mr. Vidaurre leads a team of research associates, junior research analysts, and programmers to perform research and quantitative analysis of financial data. He has experience in utilizing quantitative statistical methods and applications tosupport detailed examinations of corporate financial transactions, cash flow modeling, and financial litigation support. Additionally, Mr. Vidaurre has been involved with damages estimation, diminution of value, product liability and patent infringement analysis. He provides detailed research support for mortgage-backed securitization litigation including cash flow reconstruction to calculate insurance and trustee losses; the feasibility of utilizing statistical methodologies in the same litigation approaches, and related work products. Mr. Vidaurre is fluent in English and Spanish and has a working knowledge of Portuguese.

CONTACT US Kevin Bové 11467 Huebner Road, Ste 200 Vice President of San Antonio, TX 78230 Marketing & Sales Office: 210.641.2817 [email protected] www.AnalyticFocus.com