Monthly Archives: February 2014


What happens when you short a stock to zero? 12

Disclosure: This post contains details of historical trades made in a personal account prior to the establishment of Cable Car and does not represent recommendations by Cable Car.

The short answer is that it may not be worthwhile.

One motivation I have for blogging is to discuss elements of investing I wish I’d been able to learn about more easily when I first encountered them. There is a surprising paucity of information online regarding the mechanics of trade settlement and clearing, although the details can be relevant to the outcome of an investment, particularly a short sale. Much of what you might read on the topic is incomplete and potentially misleading. The handful of times I have been short a stock all the way until the bitter end, I was surprised at the unforeseen costs. Note that this post is specific to my experience with Interactive Brokers, but it is likely similar to the process at other brokerages.

It turns out that when a stock is delisted, short positions are not necessarily closed immediately. Short sellers are exposed to the risk of an indefinite, high-interest stock loan until shares are cancelled. For this post, I’m focusing on shares that are cancelled after a bankruptcy proceeding and expire worthless. However, other delisting events can lead to similar issues. For example, if a stock is the subject of a takeover offer, the shares may have appraisal rights. If the short position is assigned against shares that exercise these rights, the short seller would ultimately be responsible for the court-ordered compensation months or years later. More on that another time, perhaps.

Bankruptcy

When a company exits bankruptcy protection in the US, the plan of reorganization or liquidation specifies what will happen to the stock. Usually, but not always, common equity is cancelled and becomes worthless on the effective date of the plan. Prior to this, shares of bankrupt companies are traded on the pink sheets with the ticker suffix -Q. Although primarily the province of speculators and day traders, these securities sometimes still have significant market cap and liquidity, presenting a tempting short sale candidate. Sometimes this residual equity value is the result of optionality, reflecting the chance the equity ends up with a recovery. Indeed, there are many examples of how shorting a bankrupt company that is not certain to go to zero can be a very dangerous proposition:

American Airlines (AAMRQ) stock price during bankruptcy

American Airlines (AAMRQ) stock rose more than 40x from its close of $0.26 when it filed on November 29, 2011 to emergence on December 9, 2013.

However, in other situations, this option value is illusory. In the case of a pre-pack bankruptcy, for example, stakeholders have already agreed upon a plan of reorganization in conjunction with the initial bankruptcy filing. Court documents may clearly indicate that shares will be cancelled, and no near-term improvement in operating results could possibly salvage any value for shares. Up until a plan of reorganization is confirmed by the bankruptcy court, there is theoretically a risk that a proposal could emerge that would result in an equity recovery. Yet even after a plan has been confirmed, soon-to-be-worthless shares may still exhibit a great deal of volatility. These are situations where it may be desirable to short the stock (or maintain an existing short position) until the shares are ultimately delisted and cancelled.

Process

Although this post is about the trade mechanics, I’m no expert on what happens behind the scenes at the brokerage. But as I understand it, after shares are delisted, short positions are matched against long positions held at the same brokerage through a process called assignment. Opening the short position may have required the prime broker to borrow shares from another broker-dealer. If the broker can locate shares in its own inventory (from another client) to offset the short position, or if the loan was internal to begin with, then the short position can be closed immediately. The broker returns the borrowed shares to the long holder, the short position is closed, and the shares are marked to zero. The short seller keeps the short sale proceeds and the long holder the cancelled security.

On the other hand, if the stock loan was from a third party and the broker cannot assign the short position internally, the short position remains open even after shares stop trading. This is where things get problematic. If shares are available for borrow before a delisting at all, the interest rate is typically very high due to high demand. A short seller may be paying well over 100% APY on the loan and posting significant margin on the position. In the US, stock positions are settled by a central clearing house, the Depository Trust & Clearing Corporation (DTCC). While exchanges will typically suspend shares from trading after the company emerges from bankruptcy and shares are extinguished by court order, the shares do not actually cease to exist until DTCC marks them to zero. DTCC is a large organization, and the process can take a while.

I have had two very different experiences in these situations that illustrate the process.

Source Interlink (SORCQ)

Source Interlink (SORCQ) shares during bankruptcy

Source Interlink (SORCQ) filed for a pre-pack bankruptcy in April 2009 and emerged 60 days later.

Source Interlink is a periodicals distributor that restructured in 2009, after an ill-timed acquisition of a CD and DVD distribution business. The company filed a pre-pack, consensual bankruptcy that called for equity to be cancelled. Although an equity committee was formed, it was pretty clear (and had been for some time) that the enterprise value was less than the value of the outstanding debt. I shorted shares at an average cost of $0.12 and added to my position after the plan was confirmed on June 19. Shares were delisted on June 24, 2009.

Unfortunately, SORCQ was a low priority for DTCC, and Interactive Brokers was not able to assign the position internally. On June 25, the position was marked to zero but remained open. DTCC did not process the cancellation until September 3, 2009, 9 weeks later! Additionally, the SEC has a margin requirement for securities priced under $5, requiring a minimum of $2.50 in margin per share short. Due to these requirements, I had to post margin per share for the entire 9-week period, making it impossible to initiate new investments with the capital during this time. There was no way to close the position because SORCQ no longer traded, and nothing to do but wait. Given the large number of other interesting ideas in the marketplace at that time, it was probably not a worthwhile endeavor in the end.

K-V Pharmaceutical (KVPHQ)

KVPHQ shares during bankruptcy

Shortly before its plan of reorganization was confirmed, K-V Pharmaceutical (KVPHQ) shares spiked on false hope of an equity recovery.

More recently, I was intrigued by a pitch on K-V Pharmaceutical. The company is a pharmaceutical manufacturer whose sole product, Makena, has a much cheaper generic alternative made by compounding pharmacies. Despite FDA approval of Makena, sales disappointed due to lower-priced competition and the company filed for bankruptcy in 2012. K-V had nearly completed its bankruptcy proceedings when a bill in Congress last summer offered a sliver of hope to equity holders. The bill, a response to a widely publicized meningitis outbreak at a compounding pharmacy, could have limited competition from compounding pharmacies, which in turn would improve Makena’s prospects.

That may yet be the case if legislation passes in the future, but at the time of the bill’s introduction, Congress was about to go on a recess, and stakeholders had already agreed to a plan of reorganization. I shorted KVPHQ, covering after the brief entrance of Glenview Capital with a large stake, indicating possible formation of an equity committee. Surprisingly, Glenview appeared to change its mind after only a few days. Later on, KVPHQ was still available to short at $0.10 share even after the plan was confirmed on August 28.

Borrow was widely available on KVPHQ throughout the final weeks of trading; however, it was very expensive. Interactive Brokers charged an indicative rate of 120% APY; however, like many brokerages they have a policy of rounding up the collateral to the nearest $1.00. For a 10-cent stock, this meant the effective cost to borrow was a stratospherical 1200% effective rate. In other words, shorting at $0.10 would have cost more in interest charges than the short sale proceeds earned if DTCC took more than 30 days to cancel the position. Ultimately, I decided not to carry a position past the delisting, given the high borrow cost. I later learned that DTCC acted within a day of the delisting, perhaps given the higher profile of K-V relative to Source Interlink.

So is it worthwhile?

DTCC may have gotten more efficient, but there remain some short positions which stay open for months or years on end, pending action by the depositary. This presents an unacceptable risk of indefinitely tying up capital for most short sellers. The main reason to maintain such a position would be for tax purposes. If a short seller had a much higher basis from before the company became distressed in the first place, then waiting for the position to be closed would defer the short term capital gain until the position were ultimately extinguished.

Otherwise, seller beware.


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Hi, this is Jacob.

I’ll be using the first person on the blog, and all content represents my personal opinions, not necessarily those of Cable Car. I plan to discuss interesting investing-related topics, including investments I’ve made for my clients as well as companies I’m still researching. I expect the format and content of posts to vary; they may include everything from brief observations on market events to commentary on the business of investing to detailed, full-length investment write-ups. My hope is that this platform will eventually evolve into a useful forum for discussion and refinement of my ideas. I’ve been inspired by the work of John Hempton at Bronte Capital, though I doubt I’ll ever match his sense of humor.

I most likely won’t end up writing about every position I hold, but to get started I have a few historical topics to address in my first few posts. These will include:

  • A real-life arbitrage example that persisted for a few years
  • What happens when you short a stock to zero
  • Why I love odd-lot tender offers
  • A series on the investment adviser registration process

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