Category Archives : Mechanics


FX Antitrust Litigation Settlement 1

Disclosure: Cable Car is party to a referral agreement described below. Long RTRX.

As mentioned frequently over the past few years, Cable Car is a long-time shareholder of Retrophin (RTRX). Following events in 2014 that are well known, RTRX reached a modest settlement in a shareholder derivative action last year. Claims were due last June, and 15 months later, in October of this year, a few Cable Car clients from 2014 finally received a distribution from the settlement fund. After proration, the recovery was less than $0.02 per share held at the time, but it was better than nothing!

At three years from event to disbursement, the RTRX settlement was relatively quick by the standards of securities litigation. However, there was still a great deal of paperwork and effort involved in securing even such a modest recovery. As a result, I took more than passing interest in a recent solicitation from a claims recovery service offering to file similar claims on my behalf. To be frank, it wasn’t really a great use of time to file the RTRX claim. I was also intrigued because claims recovery services have an appealing business model: in exchange for dealing with the headache of filing and managing long-duration litigation claims, the service works entirely on contingency, retaining a percentage of the eventual recovery (usually 25%). That seems like a mutually beneficial proposition, especially for smaller claims. The firm that reached out to me is a public company subsidiary, and I was interested to learn more about the approach.

The most significant opportunity at the moment is a $2.3 billion antitrust settlement regarding foreign exchange rate-fixing allegations against 15 major investments banks covering expansive conduct from 2003-2015. Cable Car did not have significant activity that qualifies, but I did go through the exercise of submitting a claim for a handful of personal futures trades from 2009-10, just to see how the process works. Sure enough, it was a lot of paperwork for a claim that will most likely result in only a $15 de minimis recovery, so I can see the appeal of working with a third party.

Most large investment firms are likely to have had at least some transactions covered by the settlement. To my readers who manage investment firms or work at funds: you should look into this or mention it to your CFO. If you traded any foreign exchange derivatives or spot whatsoever (whether OTC directly with the defendants, on-exchange, or through an ECN) from 2003-2015, you are likely to have eligibility to file a claim, which could be significant.

To learn more and file a claim yourself, visit www.fxantitrustsettlement.com/index.

If this is the kind of thing you don’t want to bother with, there is also the option of engaging a third party to do it for you. When I spoke to the claims recovery service, they offered a referral fee for introductions from my network. If we already know one another and it’s something that might be of interest to you, let me know and I’d be happy to introduce you. To reiterate, you can and should file a claim yourself if you are eligible. However, if you prefer to have assistance, this post is just to somewhat sheepishly say that I’m willing to accept a modest referral fee to introduce you to someone who can help.


Is your high water mark net or gross of fees?

Cable Car does not deduct previously earned incentive fees from the high water mark. Most of the industry does.

A few recent conversations with current and prospective clients reminded me to clarify one area in which Cable Car’s standard fee structure is differentiated in favor of clients. Cable Car already offers qualified and non-US clients an unusually aligned fee model, with no management fee and a 30% incentive fee. This performance-based fee is typically crystallized quarterly, subject to a high water mark of previous performance.

The way in which the high water mark is calculated can have a material impact on the net returns received by clients. For example, suppose a $100,000 investment had gross returns of 20% during a period, for a gross account value of $120,000. After deducting a 30% incentive fee, the client’s net return would be 14%, for a balance of $114,000.

In this example, Cable Car’s high water mark for future periods would be $120,000, the gross amount before fees. By contrast, many hedge funds calculate the high water mark only after deducting the performance fee. The high water mark for these funds would be $114,000.

Cable Car Calculation Example

Period Starting Value Gross Return Fee Ending Value New HWM
1 100,000 20,000 6,000 114,000 120,000
2 114,000 2,000 - 116,000 120,000
3 116,000 (10,000) - 106,000 120,000
4 106,000 24,000 3,000 127,000 130,000

Industry Standard Example

Period Starting Value Gross Return Fee Ending Value New HWM
1 100,000 20,000 6,000 114,000 114,000
2 114,000 2,000 600 115,400 115,400
3  115,400  (10,000) - 105,400 115,400
4 105,400 24,000 4,200 125,200 125,200

With the same $36,000 in gross returns over 4 periods, Cable Car’s total incentive compensation would be only $9,000, versus the headline figure of $10,800 under a fee structure with net compounding.

For a concentrated and relatively volatile strategy, Cable Car’s approach limits the risk to clients that performance fees are crystallized at inopportune times. Cable Car is not compensated until it has “earned back” the prior incentive fee. In practice, this means that for positive gross returns, the total incentive fee over a long period of time may be significantly less than the headline fee as a proportion of the gross returns earned in the account. Depending on the actual pattern of returns and timing of fees, a 0/30 model may offer a significant long-run discount when compared to the traditional 2/20 fee model. Due to the effect of compounding as an investment grows, the absence of management fees under this structure results in the potential for significantly better net returns for clients over time.

For example calculations, questions, or comments, please don’t hesitate to contact Cable Car for more details. Depending on client needs, management fees may be more appropriate in the future to support investments in additional infrastructure as the firm grows. Cable Car’s fee structure is negotiable for large, long-term capital commitments.


(click to expand)

What fees does Cable Car charge?

For US investors who are not qualified clients, Cable Car charges a flat annual management fee equal to 3% of the account value, billed daily in arrears by the custodian.

For non-US investors and qualified clients, Cable Car waives the management fee and charges a 30% incentive fee, computed quarterly by the custodian on the net profit and loss in the account and subject to a high water mark of previous performance.

Please see Item 5 in the firm’s brochure on Form ADV for more information.

Management fee Incentive fee
Non-Qualified 3% None
Qualified None 30%


Hanergy and the Shanghai-Hong Kong Stock Connect 2

Disclosure: No position in 566 HK.

Northbound short selling has been allowed for six trading sessions on the Shanghai-Hong Kong Stock Connect (沪港通) and so far not a single A share has been sold short. It’s not yet possible at Interactive Brokers, so apparently other brokers are also still figuring out the settlement logistics.

Hong Kong-listed shares, on the other hand, remain fertile hunting ground for short sale candidates. But seller beware! The influence of Shanghai’s frothy, retail-driven stock market may be beginning to be felt. One line in a WSJ article about the recent unexplained and unjustifiable rise of Hanergy Thin Film (566 HK) caught my eye: “The company’s share price has nearly quadrupled, to HK$6.80 on Friday, since the trading link opened on November 17, making it the best-performing and most widely held stock in the program known as Shanghai-Hong Kong Stock Connect.” To what extent might retail interest have driven such a massive change in the valuation of a loss-making solar panel manufacturer whose accounting and relationship with its parent has long drawn scrutiny from shortsellers?

First, an anecdote

I am reminded of a conversation I had with my uncle in Shanghai earlier this year, a few days after the Shanghai Composite fell nearly 8% in one day. Not to pick on him, but my uncle is the quintessential retail daytrader. He and my aunt have long enjoyed telling family about their occasional speculative stock trades, but as the Chinese A-share market has heated up, they have become more serious about actively trading their savings. My 16-year-old cousin proudly told me about her first real-money three-bagger last fall, which she had picked at random. A sign of the times, perhaps?

Since I invest for a living, we were naturally very interested to hear one another’s perspectives on the stock market. It was fascinating to learn about the range of financial products and securities lending-related innovations available to retail accounts in the mainland, many of which are quite complex. But I must confess; the conversation suffered from more than the usual language barriers. It wasn’t just that I don’t recognize the Chinese name for, say, Bollinger bands (“布林线”) off the top of my head—we were speaking entirely different languages. I told him about the meeting we had had with NetDragon the day before and how I think the business trades well below asset value despite exciting growth prospects over the next 3-5 years. He responded by explaining how he only buys a stock when it has had at least 3 “red” days in a row, and that after a couple of “green” days it was time to sell. (In China, the color red is considered good luck, so the red/green negative/positive association the rest of the world uses is inverted—a small part of my motivation for choosing neutral blues for Cable Car’s logo! See the tickers in the photo below from January.)

View of stock tickers in the Shanghai financial district January 2015

View of stock tickers in the Shanghai financial district January 2015

To his credit, my uncle understands the dangers of trading on margin, unlike much of his competition, and he is quite thoughtful and careful about his position sizing. But like most of his fellow retail traders in China, he is not evaluating stocks on any sort of fundamental basis. He is a momentum trader and a speculator with a long bias, and he knows that eventually what goes up must come down.

Back to Hanergy

In my opinion, this sort of non-fundamental trading creates opportunities for fundamental investors with a longer time horizon. Conversely, it can also be a reason why mispricing persists in markets that remain dominated by retail investors. Estimates vary, but Shanghai trading is thought to still be at least 50% retail-driven, with Hong Kong around 30% according to INSEAD. In US markets, it is often clear when an illiquid, low-capitalization security has been pumped by uninformed retail speculators. There is typically a paper trail of newletters or cheerleading posts on message boards. When it comes to Hanergy, I may not be looking in the right places, but I haven’t seen the usual signs of a pump-and-dump in Chinese media.

It’s possible that interest may be arising through boiler room-style marketing by brokerage firms, but it seems at least plausible that the simple fact of the recent rise in the share price has created a momentum bubble that feeds on itself. My experience with Chinese retail investors is that they like to buy stocks that have gone up recently. On the surface, it seems improbable for a company with a US$36 billion market capitalization and meaningful float to be influenced by retail volume. However, retail interest—especially through the Stock Connect Program—has contributed a significant amount of the trading volume during the rise. Southbound trade in Hanergy has exceeded 25% of trading volume on some days, and it has represented net purchases (buy volume minus sell volume) every day except one since the beginning of February.

The chart below shows the percentage of total trading volume represented by estimated gross Stock Connect volumes as the price has increased.

Southbound Stock Connect volumes have represented 7-26% of daily Hanergy trading volume since February

Southbound Stock Connect volumes have represented 7-26% of daily Hanergy trading volume since February

For better or worse, I have been unable to secure a borrow on Hanergy, so this is more of an academic exercise for me. But it is fascinating to witness the formation of a valuation anomaly and speculate as to its cause.  Perhaps the bubble will continue as long as mainland retail money continues its net inflow into the stock.

 


The raw daily data below is from FactSet and the HKEX Daily Top 10 Southbound securities, available for trading sessions beginning February 2, 2015. *Estimated from February monthly figure.

Date Buy
(HKD m)
Sell
(HKD m)
Net
(HKD m)
VWAP
(HKD)
Est. Stock Connect Volume
(m shrs)
Total Volume
(m shrs)
Stock Connect %
2-Feb 13 6 7 $3.61 5 95 5.6%
3-Feb 18 12 6 3.64 8 80 10.1%
4-Feb 19 13 7 3.77 9 116 7.4%
5-Feb 67 21 47 4.09 22 187 11.5%
6-Feb 39 18 21 4.20 14 127 10.6%
9-Feb 34 23 11 4.22 13 79 16.9%
10-Feb 46 21 24 4.31 16 91 17.3%
11-Feb 102 25 77 4.51 28 167 16.9%
12-Feb 75 7 67 4.47 18 116 15.8%
13-Feb 55 8 47 4.53 14 104 13.3%
*17/18-Feb *10 *18 (8) 4.35 7 73 9.0%
25-Feb 58 7 51 4.48 15 60 24.4%
26-Feb 25 9 16 4.52 8 63 12.1%
27-Feb 48 7 42 4.51 12 64 19.0%
2-Mar 123 7 117 4.69 28 107 25.9%
3-Mar 138 37 101 5.10 34 178 19.2%
4-Mar 239 64 175 5.92 51 414 12.3%
5-Mar 491 337 154 7.58 109 583 18.7%
6-Mar 250 182 68 6.84 63 322 19.6%
9-Mar 154  66 87 6.65 33 152 21.7%
Total 2,005 887 1,118 $5.50  506 3,180 15.9%

 

 


CYNK: Sometimes your prime broker is looking out for you 1

Disclosure: No position in CYNK. Thankfully. This post is intended to discuss my reaction to a topical market situation. It has been edited to remove the details of trading activity in CYNK in order to avoid reference to the performance of a past specific recommendation. 

Last spring, before the Bitcoin mania had peaked and prior to starting Cable Car, I discovered a way to short BTC using a very sketchy online exchange. I briefly shorted a single Bitcoin in a personal account, covered after a small gain that almost made up for the transaction costs, and happily withdrew my balance with the learning experience as my reward. A part of me wanted to do it just to be able to say I had one day. Reasonable people may disagree over whether crypto-currencies ultimately have any value (I am not a believer), but I found the notion of shorting something truly worthless to be irresistible. Financial assets that appear to have no intrinsic value at all — pump-and-dump schemes, penny stocks, frauds, some bankruptcies — draw a certain type of value-oriented short-seller like moths to a flame. And it can be playing with fire.

The latest such sign of the apocalypse making the rounds is Cynk Technology Corp (CYNK), which I’ve seen mentioned by no less than half a dozen investors I respect. CYNK is a Belize-based pink sheets pump-and-dump, presumably, with negative shareholders’ equity, no revenue, and a vague intent to develop a social media business. Despite all that, it is a startlingly successful stock promotion scheme, with what appears to be a $4.3 billion market cap on paper after today’s 150% gain, up from $23 million a month ago. The usual pattern of such things is that after the price reaches stratospheric levels, promoters sell their shares, the share price craters, and the hordes of day traders who had helped run up the share price move on. The underlying promotion activity can be illegal, but it is very difficult for the SEC to police. I have no insight into whether any laws were broken to get CYNK to where it is today, but the outcome is the height of absurdity. The intrinsic value of CYNK, to any reasonable observer, is zero. And yet here we are, watching a bubble in action.

This post is in fact a bit of a confessional. Last Tuesday, I shorted a very small position in CYNK that I closed not long afterwards. I am embarrassed to have participated at all. At the time, CYNK was already down over 40% intraday, and it appeared to be following the classic pattern of a “dump”. The fact that a significant amount of borrowable shares had become available from my prime brokerage suggested that the float might have increased due to promoters dumping their shares. Yet when I started to think about shorting it again on the way back up this week, no shares were available. I don’t actually think it’s a deliberate policy on the part of the brokerage to withhold shares in a situation like this (that confuses cause and effect — the lack of available borrow may have actually been the cause of a squeeze), but I was willing to short CYNK at $6/share this morning, had there been shares available. Since there weren’t, I have no position, and I avoided a more than 100% intraday loss. Usually I’m not pleased when I can’t borrow a stock I want to short, but this time I am!

CYNK closed today at $14.71. Were I still short, I could have tolerated the loss, but I’d be on some level just as much of a victim as whatever gullible shareholders are buying at these prices and will ultimately be left holding the bag.

I may still short CYNK, in very small size, if shares are available when it inevitably starts to decline. That’s what I feel the need to confess! It is ineluctable, this desire to have some (very carefully sized and curated) short exposure to what David Einhorn recently called “silly prices,” while hoping they don’t get any sillier.

But there is one caveat! One thing that may just hold me back is a notion I haven’t seen any of the myriad commentators discuss: does CYNK really have the number of shares outstanding it claims? Dishonest people have falsified many many things in unaudited financial statements. Why not share count? Couldn’t that line in its filings be just as fraudulent as the business itself? According to the limited filings it makes with the OTC bulletin board, CYNK had 291.45 million shares outstanding as of March 31, 2014. Even the OTC website itself is very lackadaisical about the figure. It has a typo that misstates shares outstanding as 191.45 million, throwing the market cap off by a whopping $1.47 billion! Even if the 291.45 million figure is correct, 210 million of these are held by the founder and sole employee of CYNK, and they supposedly bear a restrictive legend (how restrictive, I wonder?) preventing them from being sold. To some extent, only the float of 81.45 million shares represents real capitalization, but even that would be pretty absurd by now at well over a billion dollars.

Instead, I question whether there really are 81 million shares floating around. Cumulative volume traded in the past 30 days, since all this nonsense began, is only 1.5 million shares. Today, despite the massive price increase, only 124,000 shares changed hands. It is not uncommon for the targets of pump-and-dump schemes to trade several times their float in a single day. Why should CYNK be different? Either there is an impressively patient group of promoters waiting to sell their shares, or an extraordinarily bullish group of long-term penny stock investors (do such people exist?) withholding millions of shares from the current frenzy, or CYNK does not actually have anywhere near 81 million shares outstanding.

I hate to rain on the parade of everyone else as excited as I was about the insanely high notional market cap, but I don’t think CYNK really has the capitalization it appears to. Based on the low trading volume, I’d guess fewer than 1 million shares are held by people not connected to the company or promoters, if they even exist at all. At, say, a $14 million market cap, CYNK no longer looks quite so appetizing as a short candidate, even with an intrinsic value of zero.


Closing the loop on GLRI 3

Disclosure: Long GLRIW, Short GLRI. This post has been edited to remove details of trading activity. This post is designed to follow up on prior analysis regarding a current investment and should under no circumstances be considered an advertisement for the performance of past specific recommendations.

Although there’s a business to run, I do aspire to follow up on blog topics when I say I will. Only a few months in and it seems I’ve already forgotten about one. (I will cover the rest of the seed topics mentioned in my first post eventually). About 9 weeks ago, I said I would discuss how to value the post-transaction Glori Energy (GLRI) business. To my handful of non-blood relative readers, sorry!

Valuing GLRI

As it turns out, I couldn’t quite get comfortable with the valuation exercise myself. I have been exiting my position in the warrants and am presently fully hedged on the remaining position. As mentioned before, Glori has an interesting model. They acquire producing oil fields, apply their proprietary technology, and if successful increase recoveries and reduce the decline rate of the field. In principle the business should be able to generate attractive internal rates of return by purchasing oil fields at an implied yield (from the seller’s perspective), increasing that yield through their recovery technology, and then selling at a premium to redeploy the capital into other fields. By repeating this process using leverage, the business could produce attractive returns over the long term.

While yields might be attractive on a project basis, the ultimate returns to shareholders are considerably more difficult to assess. It is uncertain what projects will be acquired, on what financial terms, and of course with what degree of success in improving the ultimate recoveries. GLRI’s disclosures indicated that the AERO recovery system has had mixed success, including at least one field where recoveries did not improve at all, with a great deal of sensitivity to the geologic conditions of the fields where it is deployed. From my perspective, that makes the success of the technology simply too difficult to handicap, and I will happily let others underwrite the long-term success or failure of the business.

As for valuation, using multiples of forecast EBITDA or earnings is a bit silly given the uncertain acquisition profile, though that hasn’t stopped a few sell-side firms from trying. At the arms length valuation established by the transaction and the new fully diluted market cap, the best one could do in my opinion would be to attempt to extrapolate from the yield profile of the most recent acquisition to the company as a whole. Treating the stock like a fund, assuming the technology works as promised and the company can redeploy all of its available capital in acquisitions on similar terms, what would be the notional levered cash flow yield? At least that is how I would try to approach it. The stock is a little like investing in a listed oil and gas private equity vehicle, and with confidence in the underlying technology, one could conceivably compare the prospective risk-adjusted long-term returns to similar investment opportunities elsewhere. At the current price, there is implied value to the technology. If it doesn’t succeed increasing recoveries, then GLRI should be worth little more than its net asset value. The right assessment of asset value is of course an entirely separate discussion, which depends on reserve valuation estimates, the oil price, and interest rates, but it is significantly below the current enterprise value, and there are plenty of other options for E&P speculation.

Arbitrage

As the initial write-up indicates, this was a special situation relating to a one-time transaction. I am ultimately not willing to underwrite speculation on the value of the business itself.

Meanwhile, the conversion right on the warrants has made for an interesting arbitrage situation. The 10:1 conversion window runs May 16-June 15, and creates a sort of convertible arbitrage opportunity during this period. At times during the window, it has been (and may again become) possible to purchase 10 warrants for less than the value of 1 share of GLRI. GLRI was difficult to locate early in the window, but for accounts large enough to participate in a pre-borrow program, I chose to hedge the entire warrant position by shorting GLRI. As the price of the underlying has risen closer to the $10 strike price, the warrants have become more efficiently priced. The slight premium to GLRI in the current price reflects option value over and above the conversion right. This is of course a basic idea behind convertible bond arbitrage — by owning a convertible security with an embedded option and hedging the price risk by shorting the underlying, one can capture some option premium while limiting downside. Cable Car does not generally engage in convertible arbitrage, but at the moment it offers a potentially more attractive risk/return tradeoff than selling the unhedged warrant position outright.


How odd: sometimes the little guy wins 1

Disclosure: Long HCT, watching NYRT and SPLP

“Odd lot” arbitrage is one of my favorite niches of the stock market.

The recent media firestorm about the costs and benefits of high-frequency trading (HFT) sparked by Michael Lewis’ latest book has prompted a lot of public hand-wringing about whether the stock market is fair to all participants. It most certainly is not. Retail stockbroking is in general marked by high commissions, significant hidden costs, sales loads, information asymmetries, and aggressive sales practices that put an individual investor at a distinct disadvantage to institutions. One thing it does not suffer from anymore, however, is high spreads (on most issues). Decimalization and market-making competition over the past few decades have significantly reduced the cost of market orders.

In fairness, I haven’t had a chance to read Flash Boys, so I’m not going to join the chorus of financial market participants talking their books on the relative merits of HFT. For the record, I think the latency arbitrage HFT strategies publicized by Lewis provide a net benefit to smaller investors by lowering spreads, while making it harder for large traders to execute orders without moving the market. This unusual role reversal reminds me of another instance where the tables are turned. The arbitrage opportunity created by tender offers is another delightful corner of the stock market where investors sometimes can benefit from their smaller size.

An “odd lot” or “small lot” in the US is a position of less than 100 shares. For legacy reasons, exchanges have special handling rules for odd lots, though they are now generally handled automatically. Historically, many brokerages charged additional fees for these lots, and trade pricing was disadvantageous as well. Today, odd lots do not generally incur additional costs, but at brokerages charging fixed commissions, the cost of transacting an odd lot can still be very significant relative to the transaction value.

Periodically, some public companies and closed-end funds will offer to repurchase shares at a premium to the market price. When this happens, economically rational shareholders will tender, and it is common for the offer to be oversubscribed. In such situations, the tender will be prorated, but sometimes companies will include a proration preference for odd lots. The issuer will buy the entire odd lot to spare the small holder the commissions associated with disposing of the small number of shares that would have otherwise gone unpurchased. A typical SC TO-I filing might include language like this:

Odd Lots. The term “Odd Lots” means all Shares tendered by any person (an “Odd Lot Holder”) who owned beneficially or of record an aggregate of fewer than 100 Shares and so certifies in the appropriate place on the Letter of Transmittal and, if applicable, the Notice of Guaranteed Delivery. Odd Lots will be accepted for payment before any proration of the purchase of other tendered Shares. This priority is not available to partial tenders or to beneficial or record holders of 100 or more Shares in the aggregate, even if these holders have separate accounts or certificates representing fewer than 100 Shares. To qualify for this priority, an Odd Lot Holder must tender all Shares owned by the Odd Lot Holder in accordance with the procedures described in Section 3. By tendering in the Offer, an Odd Lot Holder who holds Shares in its name and tenders its Shares directly to the Depositary would also avoid any applicable Odd Lot discounts in a sale of the holder’s Shares. Any Odd Lot Holder wishing to tender all of its Shares pursuant to the Offer should complete the section entitled “Odd Lots” in the Letter of Transmittal and, if applicable, in the Notice of Guaranteed Delivery.

The risk arbitrage set up occurs whenever shares trade below the tender price. An investor can buy 99 shares or fewer, tender at the higher price, and capture the differential within a short period of time (as little as the length of a trade settlement if guaranteed delivery is allowed). The strategy is not riskless, as tender offers can fall through for various reasons, but it is the closest thing to a freebie I have seen in the stock market.

Naturally, I am not the first to discuss these opportunities. They are frequently and often breathlessly the subject of investment blogs. The holy grail of odd lot tenders occurred in 2011 when a Russian nickel company bought back shares with a 999-share odd lot preference (thanks to a 10:1 ADR ratio) at a large premium, resulting in over $10,000 profit potential per accountholder. Most tender offers are quite a bit more pedestrian, worth a few hundred dollars at most.

I almost didn’t bother writing this post after finding an extensive discussion on an investor forum that chronicles almost every odd lot setup over the past year, along with various strategies for exploiting the technique and variations such as odd lot cashouts in reverse splits. There is even one enterprising individual offering a subscription service to send a notification of every upcoming tender offer, although this can be accomplished for free using a simple SEC filings search! Perhaps this literature review will nevertheless be interesting to someone.

Amusingly, articles sometimes spark a backlash from commenters worried the publicity will kill the golden goose. Quite frankly, I fully expect odd lot arbitrage to disappear entirely someday, as trade commissions continue to face downward pressure. Many closed end funds that conduct periodic tender offers have already removed odd lot priority. It will likely persist as long as retail brokerages charge flat fees even for small transactions, but it’s a historical anachronism that is going away eventually.

In the meantime, though, it’s a nice way to recoup some of the costs of investing. Right now, there is an opportunity in American Realty Capital Healthcare Trust (HCT), a healthcare REIT that recently listed on NASDAQ. Shares closed today at $10.20 and the company is conducting a tender at $11.00 that expires on May 2, for a potential return of $79.20 in a few weeks. Details here. As always, do your own diligence before making any investment.

At the moment, there is also a less compelling opportunity in NYRT, another newly listed REIT, and a riskier tender for SPLP, which will only be profitable at the higher end of the Dutch auction range. I am watching both and will participate only if the price falls.

Note from the sample SC TO-I language above that this is not a strategy that scales well for individuals. Separate accounts are expressly excluded. Each beneficial owner is limited to 99 shares. However, as an adviser, Cable Car disclaims beneficial ownership of its clients securities at the time of a tender. For multiple client accounts, odd lot arbitrage is at least worth the effort of this writing. Cable Car is presently long HCT on behalf of clients.

$79.20 may not seem like much, but it is meaningful for the little guy, who sometimes does come out ahead in the end.


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.