'Go to Zero' Isn't Great for Short Sellers

It's hard to bet on disaster, because that's when bets tend not to get paid off.

How far do you want it to go down?

Photographer: Spencer Platt

This post originally appeared in Money Stuff.

The way short selling works is that, if you want to bet against a stock, you borrow it from someone who owns it, and then you sell it to someone else. Eventually, you go out into the market, buy the stock back, and deliver it back to the person who owns it. If all has gone well, you will buy it back for less than you originally sold it for, and the difference will be your profit. Well, part of the difference will go to pay a fee to the stock lender, who will generally charge you a percentage for each day that you borrow the stock. But hopefully the stock will go down a lot, and the difference between your selling and buying price will more than cover that fee.

How far do you want it to go down? This seems like simple stuff: If you sell the stock for $20, and it goes to $15, you make $5 (minus the stock-lending fee), if it goes to $10, you make $10; if it goes to $5, you make $15; if it goes to $1, you make $19, etc. etc. etc., the arithmetic is pretty straightforward. And yet there are weird singularities. If the stock goes to zero, I guess you make $20? That's the goal, right? Except, what does it mean for a stock to go to zero? If a stock goes to $1, that means that people are buying and selling it on the stock exchange for $1.00. But if it goes to zero ... who is selling stock for $0.00? "Go to zero" is a conventional expression, especially popular among short sellers, but you have to be careful with it. If a stock "goes to zero" by going from $20 to 2 cents, or if it "goes to zero" through a formal bankruptcy process, then that is a pretty unequivocal win for the short seller. But some other paths to zero are ... actually ... bad?

Gates says he is stuck short China-Biotics, for instance, a stock that was halted in November 2013 when the Securities and Exchange Commission revoked its registration. The shares were delisted, and the company shut down. Gates showed us a January 2018 letter that he says he sent to the stock market record keepers at The Depository Trust Co., in which he laments that a TFS mutual fund has paid hundreds of thousands of dollars in stock-loan fees on China-Biotics and remained subject to the $2.50 a share margin required by Financial Industry Regulatory Authority rules. A handful of other short positions have him in the same predicament.

Gates is Rich Gates of TFS Capital, who "has joined an industry committee that the Securities Industry and Financial Markets Association calls the Worthless Securities Working Group." He shorted some stocks that he thought were frauds, and the SEC agreed that they were frauds and halted them, and then ... things got worse for him. The shares were worthless, but they didn't trade at zero or $0.01 or whatever: They didn't trade at all, so he couldn't buy them back to deliver to his stock lenders. Here is his letter to DTCC, which notes:

DTCC maintains securities in its records indefinitely that are worthless and illiquid; these securities have not been "taken down" by DTCC despite the fact that they have been deregistered by the SEC, delisted by the exchanges, have no existing business location, operations, management or employees and their registration is not in good standing in their state of incorporation. 

Gates blames the brokers who loaned him the stock for this situation (and calls it "a glaring conflict of interest" for them), but that is not the whole story. "Gates’ prime brokers aren’t necessarily pocketing stock-loan fees—they may have to pass them on to other firms that supplied the borrowed shares," notes Bill Alpert at Barron's. The only way to (legally) short stock is to borrow it from someone who owns it, and your stock borrow fee makes its way back to that owner-lender (with brokers taking a cut). The actual conflict is that whoever was long China-Biotics stock is still making money from it in its limbo; if the stock borrow fees are high enough and the limbo goes on long enough, they might make more from the stock borrow fees than they would have if the company had been successful. The incentives in stock lending are always a little weird -- you are making a little extra money on the stock you own by helping someone bet against that stock -- but here they are downright perverse.

Obviously this result is Wrong, and should probably be solved. ("Put them on the blockchain," you might shrug, though of course this problem has nothing to do with tracking ownership; it's about deciding when a company is not a company anymore, which is harder to blockchain.) Obviously the situation is not fun for Gates. I confess that it makes me rather gleeful. It is Wrong, of course, but it is Wrong in such an evocative way. It is, structurally, hard to bet on disaster, because when a disaster happens, that's when bets tend not to get paid off. If you bet on the end of the world, and you are correct, no one will be around to pay you. If you bet on the collapse of the financial system by buying credit-default swaps on banks, then you are probably buying those swaps from banks, and you'll have trouble collecting if your bet comes good. But that is true even in miniature: Even if you bet on a disaster for some penny-stock fraud, and even if that disaster occurs exactly as you predict, you might get swept up in it as well.

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