GameStop and the Reemergence of the Retail Investor

Posted by Jill E. Fisch (University of Pennsylvania), on Friday, April 8, 2022

The GameStop trading frenzy in 2021 marked the reemergence of the retail investor in the securities markets. An unprecedented number of new and largely inexperienced investors opened app-based brokerage accounts and began trading so-called meme stocks issued by companies that included GameStop, AMC and Express. Interest in these stocks, which was fueled by postings on social media, led to high levels of market volatility and charges of market manipulation. The price of GameStop alone soared from less than $4/share to a high of $483/share. During the course of the frenzy, several hedge funds that shorted the meme stocks suffered significant trading losses, at least one retail-oriented brokerage firm faced dramatically increased capital requirements forcing it to limit trading temporarily, regulators demanded information, and Congress held four hearings to determine what happened and whether regulatory reforms were warranted.

My paper, GameStop and the Reemergence of the Retail Investor, forthcoming in the Boston University Law Review, recounts the story behind the GameStop frenzy. It identifies key factors contributing to the reemergence of retail trading, the focus on meme stocks, and the growing power of social media. The GameStop frenzy was distinctive in that it reflected not just stock purchases by a substantial number of retail investors, but the demonstrable impact of those purchases on capital market pricing and volatility. This impact was facilitated by a decline in traditional barriers to capital market participation such as user-friendly brokerage apps, zero-commission trading, and the ability of small investors to purchase fractional shares. An unprecedented use of social media fueled retail engagement in the market even as it has raised questions about the wisdom of investors relying on social media posts to inform their investing decisions. Although the GameStop frenzy may be a product of the times, driven by the confluence of the pandemic lockdown, the liquidity of stimulus checks and the lure of virtual confetti, the reemergence of direct retail investors offers the prospect of a fundamental change in the capital markets. As such, it raises new regulatory questions.

In particular, the GameStop frenzy blindsided regulators that had largely become accustomed to the invisibility of the retail investor. In recent years, most retail investors participated in the capital markets through intermediaries such as diversified mutual funds, retirement plans and professional advisors. The role of these intermediaries was to shelter retail investors from the risks associated with direct investing—the risks of poorly informed trades, insufficient diversification, costly products, and fraud. Regulators focused their attention on protecting retail investors from these intermediaries by questioning the size and structure of their fees and seeking to mitigate potential conflicts of interest.

The result of this intermediation was tremendous growth in the size and importance of institutional investors. Institutional investors took up the mantle of effecting market discipline through their trading decisions. Similarly, institutional investors became the driving force behind shareholder voting. Most recently, institutional investors have been using the voting power that they exercise on behalf of their beneficiaries to demand that issuers pay greater attention to ESG issues such as climate change. Commentators now worry that institutional investors exercise too much power—that their herding behavior jeopardizes market stability and that their common ownership limits the competitive behavior of their portfolio companies. Remarkably little attention has been paid, however, to retail investors.

The GameStop frenzy upset these norms. It led to calls for greater regulation as critics argued both that retail investors need to be protected from the capital markets and that the capital markets need to be protected from retail investors. The frenzy prompted a flurry of reform proposals including restrictions on payment for order flow, transaction-based fees or taxes, limitations on the use of social media in connection with securities trading, and increased compliance requirements for brokerage firms that serve the retail market. In the paper I question the premise for these regulatory reforms and argue that the harms cited by proponents of reform are overstated. In particular, the paper challenges the idea that it is dangerous or inappropriate for retail investors to purchase securities that are traded in the highly regulated U.S. public markets, securities of corporations that publish regular periodic reports about their financial condition and business operations that are audited and subject to SEC oversight for accuracy. The paper also demonstrates that the claims of retail investor irrationality have been overstated. At the same time, the paper cites evidence that the GameStop frenzy has engaged a growing number of ordinary citizens in the capital markets, that those citizens are younger and more diverse than traditional investors, and that their participation extends well beyond short term speculation.

GameStop and the Reemergence of the Retail Investor offers instead a new look at the retail investor and the potential impact of direct retail investing on both investors and the capital markets. The central contribution of the paper is to make the affirmative case for the benefits of increased engagement by retail investors in the capital markets, benefits that have largely been overlooked in the debate over regulatory reform. As the paper explains, retail investing has the potential to increase the involvement of ordinary citizens, including a population that has not traditionally participated in the capital markets, in the country’s economic development. This participation has the potential to lead to a more equitable distribution of corporate profits and to facilitate the ability of traditionally excluded groups to build wealth.

Retail investing can also enhance the voice of regular people in corporate decisions. So-called inclusive capitalism can increase corporate accountability. Signs of such accountability can already be found in the use by retail investors of the shareholder proposal process to demand increased disclosure of controversial corporate practices from political spending to human rights. Corporate executives have recognized the growing importance of retail and are developing new strategies for engagement including the use of social media. Market participants are developing new tools to enable retail shareholders to leverage their voice and increase their influence. Significantly, direct retail participation in the markets offers distinctive advantages, not available through intermediaries, that facilitate the engagement of ordinary citizens in corporate decisionmaking through their investment decisions, voting power and participation in corporate governance.

The paper further explains that retail investing can mitigate the problems associated with the concentrated power of institutional investors. Scholars have identified the potential agency costs resulting from institutional intermediation, costs that are increased as institutions broaden their focus from economic value to a broader range of social and political issues. Direct retail investing also constrains the potential for institutional conflicts of interest to affect portfolio companies.

Finally retail investing offers a mechanism for increasing corporate attention to stakeholder interests within the context of a shareholder-based governance structure. The extensive debate over stakeholder governance highlights the potential for stakeholder interests to conflict with shareholder interests, a conflict that complicates the exercise of fiduciary duties by both corporate decisionmakers and institutional investors. In contrast, retail investors incorporate and balance their own individual interests as customers, employees and committee members, as well as shareholders, into their engagement with their portfolio companies, leading to a type of “automatic stakeholder governance.” This engagement enables heterogeneous shareholder preferences and diverse perspectives to be considered in a corporation’s operating decisions.

The GameStop frenzy does not appear to have been a one-off event; there are signs that the growth of retail investing is continuing. This growth creates new costs and challenges for both investors and the capital markets. Investors will make mistakes and lose money. Stock prices may be more volatile, and traditional market participants will have to adjust their behavior to account for the reemergence of retail. Rather than focusing on keeping retail investors out of the market, however, this paper argues that the lesson from the GameStop frenzy for regulators is the need to focus on understanding the new drivers of retail investing and how to ensure that those drivers can best promote informed and efficient investing behavior. Toward that end, the paper concludes by identifying several cautionary considerations triggered by the growth of retail investing that warrant further scrutiny.

The paper notes that the younger investors rely heavily on non-traditional sources of investment information, particularly social media. While the potential of social media to provoke, to manipulate and to disseminate misinformation is not limited to the investment sphere, the potential influence of social media on investor behavior warrants continuing oversight by the Securities & Exchange Commission. The SEC should be particularly attentive to the use of social media platforms by securities professionals and should consider the extent to which such use is consistent with existing regulations.

The paper further considers the current debate over digital engagement practices triggered by the role of app-based brokers in the trading of GameStop and other meme stocks. The paper challenges arguments that user-friendly platforms or free stock promotions are inherently harmful, and notes that traditional regulatory standards such as the suitability requirement and Regulation Best Interest should, if enforced, provide adequate safeguards to protect customers. At the same time, the paper highlights a distinctive risk that app-based brokers could potentially collect and misuse customer information to manipulate investment behavior.

Finally, the reemergence of the retail investor provides new reasons to be concerned about the ongoing limits to investor financial literacy, in light of studies continuing to demonstrate that investors lack a basic understanding of many investment products and account features. Fintech and social media offer powerful tools for increasing the demand for and the effectiveness of financial education. Although market participants are beginning to use their digital features to promote financial literacy, the paper argues that regulators could provide a “nudge” toward greater innovation and use of tools for effective financial education.

The complete paper is available for download here.