Professor John Orcutt dives into the explosion of Gamestop’s stock stemming from reddit’s WallStreetBets, covering short selling, bubbles, and possible legal exposure of those involved. Produced and Hosted by A. J. Kierstead
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Legal topics include securities, investing, short selling, internet
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A. J. Kierstead:
Professor John Orcutt dives in the explosion of GameStop's stock stemming from Reddit's WallStreetBets. This is the Legal Impact, the weekly podcast presented by the University of New Hampshire Franklin Pierce School of Law, now accepting applications for J.D. graduate programs and online professional certificates learn more and apply law.unh.edu. Opinions discussed are solely the opinion of the faculty who hosts and do not constitute legal advice or necessarily represent the official views of the University of New Hampshire. So John you're our resident securities expert, and there's is a story I've been itching to cover. There are a few different legal angles on the subject, but let's start with the root of the matter WallStreetBets, a Reddit forum that talks stocks went full bore on GameStop on the stock market. It's a video game store in pop culture merch retailer that was very popular just a few years back, but with the transition to digital, their whole ecosystem has changed and it's been really rough on them.
A. J. Kierstead:
There were two main reasons for this first, at least this is what they said on Reddit. The two main reasons were that they're are a bunch of millennials they grew up going to GameStop and they didn't like seeing that it was kind of going down in the market and having a rough go. The second word is also that word got out that many hedge fund managers were shorting the stock and they didn't want that to happen. And it was just this online war that they wanted to have happened. Are there any inherent legal angles with just this initial look at the situation?
John Orcutt:
The big legal issue is going to be whether there's any market manipulation taking place and this is an interesting one, because there could potentially be market manipulation on both sides of the equation. There is frequently concern when investors go in and short stock that they have potentially an incentive to speak badly about the company in a way that exaggerates the negatives of the company and to potentially do so in a fraudulent way. And then on the other side, you've got the Reddit forum that is fighting the shorts and as a result wants the stock price to go up. And so they may have an incentive to exaggerate about the good sides of the company potentially in a fraudulent way and then cause the stock price to go up. So just from a legal angle and one of the areas I do expect regulators will be looking at is going to be both on the short side and on the long side, whether there's any market manipulation going on.
A. J. Kierstead:
Can you give a basic overview of what shorting a stock actually means?
John Orcutt:
So the easiest way to talk about it is, shorting a stock is selling stock you do not own. And the concept is, and I know to the audience that may sound like that's terrible, how can you sell something you don't own? What you're doing is you borrow the stock from typically from your broker and then you sell it, right? So when you're selling something you don't own, it's selling something that you borrowed, you have gained possession of the securities and then you sell it, right? That's the typical way that you do it. Now, there are other ways that it can be done, but that's sort of is the typical structure. Now, when you borrow something, at some point you have to return it. And so at some point you have to go back into the market and purchase the stock that you borrow.
John Orcutt:
If the stock price has gone down, you make money. So example, let's say you short the stock at $50. What that means is the stock price is currently trading at $50 so you can sell the stock for $50. You don't own it, you borrow it probably from your broker who will charge you a fee for borrowing stock. You sell it at 50 so you make $50 for each share. Let's say the stock price goes down to $30 per share and you go, "Okay, that's good enough. I think that's where it's going to bottom out." Or, "I've made enough profit. I'm comfortable." I go out, I rebuy the stock at $30. I return it to the broker and I pocket that $20 profit minus my administrative costs for doing the deal.
A. J. Kierstead:
Now, this inherently supports the devaluing of a stock, correct?
John Orcutt:
So yeah, from a basic economic standpoint. One of the things shorting does is it increases the volume of the stock, right? So if you go back to you and your basic economic analysis, if demand has stayed constant and supply increases, it's going to put some downward pressure on the stock and all that's fine, no issues there. What sometimes happens and this isn't the issue people are talking about today, but it's the issue that frequently people would be talking about is as a short seller, am I now going to go out and start bad mouthing the company? Because once I go short on the company, it's in my best interest for that stock price to go down. One way that the stock price can go down would be to start saying lots of bad things about it. And in fact, you've got other issues where you've got blogs and I will say I'm not a big Reddit person.
John Orcutt:
So I don't follow all the various Reddit forums out there. I'm confident there are Reddit forums out there though that focus more on the short side. And then the question would be is some of what they are saying... Are what they're saying, driving the stock price down and are they doing that in a manipulative manner? So you start making up fake stories. Do you start making a fake stories and get those fake stories potentially posted on the myriad of different securities and stock blogs out there? So it starts to look real and then hope that story becomes kind of viral, potentially pushes down the stock price. You go out, you repurchase your stock, you've covered your borrowing and you're good to go. That's one potential issue that could be looked at, although that's not exactly what's going on in this story, but once you start going shorts, longs, my guess is that the regulators, whether it's the SEC or Congress would be looking at both sides.
A. J. Kierstead:
Yeah, basically this was the opposite way where the small time investors were just hammering in order to cause these short sellers to lose essentially an infinite amount of money, if they just kept going, if the stock just continued to go up.
John Orcutt:
Right and one of the things when you're talking about shorting is it is an inherently risky or strategy because when you cover, it could potentially be an unlimited amount of money. If I buy stock at $50 a share and it loses all its value, I lost $50 a share. If I short stock at $50 a share, in theory that stock price could increase infinitely, right? It could go up to a trillion dollars a share. It's not going to go up to a trillion dollar share, but in theory it could and so my potential losses as a short trader are potentially infinite.
A. J. Kierstead:
So is there any legal issue with promoting that, "Hey, these guys are short-selling it. I don't like this to happen. I want them to lose a lot of money. I'm going to now put a huge PR campaign on Reddit to attack them?"
John Orcutt:
As long as you're being honest about your behavior, the fact that a group wants to get together and fight back against shorts, there's nothing inherently wrong about that. Now, if what they are doing is making material misstatement. So if they are making false statements about the company in order to encourage the stock price to go up, that would be a problem, right? That's when you start running into securities violation.
A. J. Kierstead:
Yeah. And this went totally viral across the web. I mean, is there any legal trouble for the GameStock's crowd? Is basically the meme is what it's called on Reddit. I mean, the guy deepf-ingvalues is just one of the guys that kicked this whole thing off. I mean, is he in any risk at this time point?
John Orcutt:
As long as he was making truthful statements, then he shouldn't have any problem. Where you run into a problem will be, again, if you are making a material misstatements and one of the risks of how this gets done is, I think on some of these Reddit blogs, there's almost a game, there's this urge to be more outrageous than the last person and it's all being done in writing. Right? So to the extent that somebody does want to look at it, whether it is potentially a private investor who wants to sue you privately or whether it's a regulator that wants to look at the matter, you've got a nice, long written record to look at. And most of your statements are not statements that have been carefully parsed by a lawyer. So the typical gain when you're looking at when companies' CEOs, CFOs, directors are talking about their company in the market, their statements are for the most part crafted and worked through with lawyers to make sure that sloppy statements don't become fraudulent statements. And none of that's occurring right here, so there's risk-
A. J. Kierstead:
This even blew up on Twitter. I mean, you got me meme lord billionaires, like Elon Musk going out there, tweeting, trying to promote this push. And it's just crazy.
John Orcutt:
Well, and I would just say some of the players who are getting involved in this game now have a conflict of interest. So I just think that and this is nothing against Elon Musk, but I would be careful in listening to his views on this particular matter, because he's got an inherent conflict of interest. Tesla is a company that frequently has had big, strong, short pushes against it so he doesn't like shorts. The function of shorts, there's a bunch of functions that maybe some of the listeners have heard about like they can help with market liquidity. So there are these really technical functions of shorting behavior that I think everybody in the market would say, "That's good. We want to have that happen."
John Orcutt:
So let's say for example, you do an initial public offering and a bunch of people want to buy your stock and there's nobody on the other side of the trade to sell their stock. Well, there might be a broker who then sells the stock to you, even though the broker doesn't have it because they know throughout the day, there'll be times where they can then come and capture that stock. That's okay, that's a really healthy form of shorting. And then there's also the concept that shorting helps to prevent bubbles although of course, here we've got a huge bubble that's occurring with GameStop. It is healthy to have people in the system whose goal is defined stocks that are overvalued, right? That's good for the market and it improves market efficiency. One of the most famous shorts ever is Jim Chanos who's the one who uncovered the Enron Scandal way back when, that is a healthy function for short-stock. If you're the CEO of a company though, you don't like people whose job is to try to push down your stock price.
A. J. Kierstead:
Then now there's been this interesting debate back and forth between the internet crew versus kind of the mainstream media and the analysts where there's all this back and forth between... On the internet they're saying, "This is great. We just love the stock. We want to support the stock because we love the stock." Is basically the champ that's going over, "Hold the line, support the stock." On the mainstream media and the analysts, obviously this goes against what they push. I mean, they want this kind of more, the way business as usual has been with handling of stocks. Do you see new regulations coming out, what's kind of caused this bubble to happen?
John Orcutt:
I mean, honestly, this is not the first short squeeze. This is probably the one that has gotten the most media attention, but there've been short squeezes similar to this in magnitude that have taken place in the past. Some in the not too distant past, there was a company Tilray that went through a massive short squeeze in 2018, Volkswagen went through a massive short squeeze in 2008. This has happened before and for the most part, it washes out. Is this something that requires massive regulation? I don't think so. There's nothing wrong with the SEC ever looking at matters and identifying if there's something that could require a little tweak here or there, I don't think this is something though that's screaming for massive regulation.
A. J. Kierstead:
But this is also a brand new world, because I mean, a good part of what's happened here is there's now these ecosystems like Robinhood, which weren't there a decade ago that now allow anyone to go in, buy partial stocks, full stocks, and getting in on the game from any mobile device. And they actually had some problems when they actually shut down trading on their app and some instance even sold some users stock back of GameStop. I mean, what's your take on all that? I don't even know where to begin on the-
John Orcutt:
Let me just start with the idea that this is a brave new world. Ah, maybe, that's one of the things about being lawyers is we get to see all this bad stuff that frequently takes place over long periods of time. And what may seem like something brand new to individuals that are just beginning, they're just coming into the game, looks brand new when it's actually this is something that's occurred in the past and maybe it's not that novel. Now the one thing I'd say in this markets are brutal, right? Markets work by punishing bad decisions so in this case you've got group and it's true we've suddenly democratized a fair amount of money and that money is going and taking on the hedge funds.
John Orcutt:
Now what's happened to that money? If I can just give you a couple of numbers so we can start to appreciate, because obviously our conversation here was fine, we start talking about kind of the edge issues here. When for me, this is really about what is the intrinsic value of GameStop, because in the end investing is about purchasing assets that will return to you more money than it costs you to purchase the assets, right? Now, in general, if I'm buying GameStop based on its intrinsic value, what I'm doing is I'm purchasing stock that I believe will give me right to future cash flows from GameStop, either in the form of dividends or in the form of an eventual liquidation of the company. At some point in the future gets sold to somebody else for cash, that provide those future cash flows the present value of them is greater than the stock price that I'm paying today. That's fundamental mentally, what is occurring when you are doing valuation?
John Orcutt:
Now I will say I spent a little bit of time on the Reddit blog. I don't believe that most of the individual who are on the Reddit blog one, I don't think that's how they're doing their valuation analysis two, I don't think most of them are doing any valuation analysis at all and instead they're investing base based on emotion. Now you're allowed to do that. And the way we regulate our markets, for the most part, if you're playing the game, normally you can make really bad decisions you can make them based on emotion, you can make them based on astrological signs, whatever you want. And for the most part, we've tried to create an environment that's relatively safe so that people who are making really bad decisions, don't lose all their money, right? Now, if you want through the system and you can choose to go out and lose all your money, that's what's going to happen in most of the individuals I believe who are playing in the GameStop game.
John Orcutt:
Back to numbers. Before this started, if you were to go back and look at the month of July, GameStop was trading at about $4 per share that translates into an enterprise value for the company of roughly $250 million as the value of the company and what that means, just sort of a translation. If you were to be the sole owner of GameStop, you are expecting that for the infinite future of GameStop, all of the future profits that it's going to, that it's going to be generating the present value of all those future profits, somewhere in the range of $250 million, right? That's what you're projecting and it's all based on projections. People going to have different views about that so somebody might think that's a little undervalued, somebody might think that's overvalued, but the market, as a whole was thinking, this is about a $250 million company. When its stock price hit, and this I'm just going with the closing price, because I know there were some inner day trading that was a little bit different. On 27th January, was it's highest close $347.51. Now, it's implied enterprise value, $24 billion.
A. J. Kierstead:
It's a flailing retailer so that's just crazy.
John Orcutt:
So 100 times higher than when it was being valued in a more normal market. And again, just to me, I don't think you can get any rational person who's going to say to you that value, $24 billion for game stop is correct. Now, here though, people are investing... They're not investing based on buying something based on its intrinsic value, I'm buying something based on the fact that I think there's somebody out there that will in the very short term pay more for it, right? So that's why we got a bubble. We're not in normal value investing, now we're in bubble territory. And the theory for the Reddit users is because there's this massive short position at some point, those shorts have to cover. We're going to squeeze them. If we go in, buy up a bunch of stock, push up the stock price at some point they're going to have to cover. And when they cover, they're going to have to buy it at whatever price. And we're going to dictate the price, forcing them to cover.
John Orcutt:
A lot of the coverings already occurred and some of those hedge funds lost significant amounts of money, billions of dollars. So two of those retail investors. Those retail investors who were buying and pushing that stock price up to $347 and at one point it was over $400 a share. I think he got close to $500 a share. Well, now it's trading at about $90 a share, what happened to all those retail investors and their money? So if you bought in at $400 and it's at $90, well, I just lost $310 a share. I can't play in the next game. This was it, I had one game to play and I just spent all my money.
A. J. Kierstead:
They don't care though. That's the difference here in this situation though.
John Orcutt:
But I don't have any money left to play next time. So that's what I'm saying it's not like... Well, this is going to happen again and again. Some individuals will have made money. Anytime you have a bubble, if you're in early, you make money. But in order for that bubble to work, what is more money comes in late and they don't make money and they lose their money and so they're not going to be as willing to play the next time. One, because well, you lost your money, that's not a very smart strategy. Or two, I don't have any money left. And for many of these individuals, they weren't investing in the typical long way where they went out and bought the stock. They bought options. And if those options expire at a point when they're not in the money, I lose all of my money.
John Orcutt:
So if I really want to go in strong, which is really a big part of this, GameStop. Honestly, it's like going to a toxic masculinity forum. It's all about go big or go big. You got to be brave and macho and this is a war. And so one of the ways you can go in heavier is to go out and purchase a bunch of options. Well, if my options expire and they're outside of the money, I lost my entire investment. All of it, gone by putting $20,000 or $2,000 gone, that might've been all the money I had to play with.
A. J. Kierstead:
We're running out of time here. Can I have you come back at some point in the near future so we can dive deeper into Robinhood and what went on?
John Orcutt:
Sure. I would love to do that.
A. J. Kierstead:
All right, that'd be awesome. All right. Thanks everyone for listening to the Legal Impact presented by UNH Franklin Pierce School of Law. To help spread word about the show, please be sure to subscribe and comment on your favorite podcast platform, including Apple Podcasts, Google Play and Spotify.
