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Beaten-Down by GameStop Stock, Melvin Capital is Now Under SEC Scrutiny

Melvin Capital paid a heavy price for betting against GameStop last year. But the now-defunct fund is in more trouble. A recent report revealed the SEC is investigating Melvin Capital for misleading clients about its strategies.
  • Melvin Capital lost 57% of its capital due to its short position in GameStop, which skyrocketed during the “meme rally” of January 2021.
  • The SEC is investigating Melvin Capital for allegedly misleading clients about the fund's risk controls and investment strategies.
  • The fund closed in May of this year, returning money to all investors after reporting sizable losses.
Figure 1: Beaten-Down by GameStop Stock, Melvin Capital is Now Under SEC Scrutiny

Figure 1: Beaten-Down by GameStop Stock, Melvin Capital is Now Under SEC Scrutiny

(Read more from Wall Street Memes: BBBY Stock: Meme Season Has Begun)

The SEC Is Investigating Melvin Capital

According to the Wall Street Journal, over the past few months, the SEC (Securities and Exchange Commission) has been in contact with investors of Melvin Capital about possible misleading practices taken by the fund during 2021.

The SEC is trying to ascertain whether Melvin Capital’s main investment fund had proper risk controls and offered sufficient investor disclosures. Clients who were invested in Melvin’s fund at the start of 2021 lost about 57% of their money – that means Melvin’s fund would need to generate triple-digit growth just to have its clients break even.

One of the reasons behind Melvin’s massive loss was the fund's short position in GameStop  (GME) - Get GameStop Corporation Report. In January 2021, retail investors, working largely via Reddit platforms, pushed a historic short squeeze in GameStop shares. Melvin Capital, being a major short seller, took a huge hit.

The fund also held other short positions, including in famed meme stock AMC Entertainment AMC, as well as other, less-meme-y stocks, such as Cryoport  (CYRX) - Get CryoPort Inc. Report, Viatris  (VTRS) - Get Viatris Inc. Report, and Invesco's Solar ETF  (TAN) - Get Invesco Solar ETF Report.

Winding Down The Fund

After suffering big losses at the beginning of 2021, Melvin’s fund scraped by for the rest of the year. Then, in the first four months of 2022, Melvin lost another 23%. According to internal fund sources, Melvin’s loss during this period came mostly from long positions, which were hammered by poor macroeconomic conditions.

Melvin Capital tried to reverse the situation, announcing in February of that year that it would create a “long-only” fund to regain investors' trust. But apparently it was too late. A few months later, Melvin finally threw in the towel, admitting that the next step would be to wind down the fund.

In a letter written on Wednesday, May 18, Plotkin stated "The appropriate next step is to wind down the Funds by fully liquidating the Funds' assets and accounts and returning cash to all investors."

Gabriel Plotkin Testimony On Meme Stock Investigation

The U.S. House Committee on Financial Services released an extensive and detailed report of its year-long investigation into what it has dubbed the January 2021 “Meme Stock Market Event” (MSME).

Since the MSME, the committee has held a series of virtual hearings titled Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide.

Lawmakers expressed concern about the role of market makers in the trading of shares of GameStop, AMC Entertainment, and other highly volatile stocks.

Melvin Capital’s founder, Gabriel Plotkin, was one of the witnesses subpoenaed to testify about the MSME. During his testimony, Plotkin called the events of early 2021 "unprecedented." He claimed that Melvin Capital had not interfered in the decision of trading platforms (such as RobinHood  (HOOD) - Get Robinhood Markets Inc. Report) to limit trading on GameStop.

Plotkin also said that Melvin had closed out all its GameStop positions a few days before the trading platforms put the limitations in place.

Regarding the fund's investment strategy, Plotkin stated that Melvin specialized in consumer and technology companies and that most of its investments were long, not short. He said the fund was focused on business fundamentals and making returns over the long term.

However, when Melvin's extensive research concluded that a company was overvalued in share price, the fund would open a short position.

Plotkin concluded by saying that Melvin also shorted stocks because of its commitment to protecting its clients' capital when the market falls.

"It is very important to understand that absolutely none of Melvin's short positions are part of any effort to artificially depress or manipulate downward the price of a stock," Plotkin remarked.

Regarding its decision to short GameStop, Melvin Capital stated its belief that the brick-and-mortar video game retailer’s business model was simply outdated. The pandemic, which began in early 2020, had also accelerated home downloads of video games, which helped spur significant losses at GameStop - even while the overall gaming industry had its best year to date.

The Bottom Line

Melvin Capital 2014 was already famous – or notorious – for its success with short strategies. In its first year of operations, the fund returned 47%, ranking second on Bloomberg's list of top-performing funds.

Until 2020, Melvin Capital's trajectory continued to be positive. The fund charged its clients an annual management fee of between 2% and 30% of profits - among the highest fee structures in the hedge fund industry.

Melvin was profiting from its short positions in GameStop stock until 2020. The fund had been short GME since 2014.

It would have been tough for even the staunchest GameStop short seller to have predicted the unprecedented squeeze of 2021. But funds should have at the very least been aware of their significant margin risk. And now, it is up to the SEC to scrutinize the fund strategy disclosures Melvin Capital provided to its clients.

While this investigation chugs along, it's also important to note that several hedge funds continue to hold significant short positions in GME, even the company’s short ratio – and squeeze risk – remains elevated. 

(Disclaimers: this is not investment advice. The author may be long one or more stocks mentioned in this report. Also, the article may contain affiliate links. These partnerships do not influence editorial content. Thanks for supporting Wall Street Memes)