Even Short-Sellers Burned by Chinese Shares

By BILL ALPERT | MORE ARTICLES BY AUTHOR

When trading in the underlying shares gets halted, highfliers can pay a steep price.

• Article
• Comments (2)

The epidemic fraud affecting dozens of U.S.-listed China stocks is one of this year's big newspaper stories―after being one of last year's big stories in your favorite stock-market weekly (see "Beware This Chinese Export," Barron's, Aug. 28, 2010). But the scams that have disgraced many Chinese listings on Nasdaq and the NYSE weren't unmasked by the exchanges, auditors, investment bankers or market regulators. The detective work was done by research-oriented hedge funds, who found the lies behind these multibillion dollar stock promotions, shorted the shares, and then blew the whistle.

View Full Image

Gary Hovland for Barron's

And for that public service, the shorts have been punished in an unexpected way.

When the auditors of firms like Longtop Financial Technologies (ticker: LFT) or China MediaExpress Holdings (CCME) resigned, voicing concern about possible fraud, the exchanges halted trading. More than a dozen such halts have occurred this year and, as shown in the table at left, they've dragged on for as long as three months. Regulations bar trading in listed stocks during a halt. That leaves stock-option traders unable to exercise, and equity longs and shorts trapped in their positions. But there's a more arcane problem for the short-sellers: Throughout the halt, they must continue to pay interest-like fees on the shares they borrowed to make their short sales. These fees―known as "negative rebates"―can run at rates as high as 180%, annualized.

After Nasdaq's halt of China MediaExpress on March 11, one hedge-fund manager, who'd been way ahead of auditor Deloitte Touche Tohmatsu in concluding that the Hong Kong-based bus advertiser had lied about its business, found himself wasting millions in rebates under a stock-loan contract that pegged the rebate to the stock's last traded price of $11.88. The shares were clearly not worth $11.88. When China MediaExpress resumed trading over-the-counter May 19, after Nasdaq took nearly 70 days to delist it, the shares dropped to about $1 (as shown in the chart, below).

"Congratulations. You were right, this is a fraud," the short-seller imagined Wall Street firms telling him. "Now we're going to lock you into a negative 90% rebate contract for an indefinite period of time."

China MediaExpress and Longtop say they're addressing the concerns of their ex-auditors. Nasdaq didn't respond to numerous phone calls and e-mails. In fact, nobody involved in the China-stock rebate mess would discuss it on the record: not the hedge funds, not the prime brokers who serve them, not the securities lenders at custodial firms.

Fortunately, they are talking to each other. In the last couple of weeks, regulators from the Securities and Exchange Commission, the Financial Industry Regulatory Authority and members of the securities-lending industry have huddled to develop new ways to let sophisticated investors close out long and short positions during an extended trading halt, while disseminating the resulting share price for use in calculating rebates paid by shorts who want to maintain their bets.

Ouch, That Hurts!

Halted for months at prices that can't be right, these China stocks scorched shorts, too. Most recent halts listed first.

Company / Ticker	Price at Halt	Market Cap at Halt (mil)	Days Halted (Through 6/17)
Yuhe Intl / YUII	$1.21	$25	1
China-Biotics / CHBT	3.46	77	3
Jiangbo Pharma / JGBO	3.08	42	18
Longtop Fincl Tech / LFT	18.93	1,080	32
Wonder Auto Tech / WATG	5.42	184	43
China Integrated Energy / CBEH	1.84	73	56 1
Duoyuan Global Water / DGW	3.88	95	59
China Ritar Power / CRTP	1.60	35	61
Universal Travel Group / UTA	3.96	79	67
Puda Coal / PUDA	6.00	180	68
Subaye / SBAY	2.15	20	72
Keyuan Petrochemicals / KEYP	4.88	281	78
China Elec Motor / CELM	2.91	64	75 2
NIVS IntelliMedia Tech / NIV	2.21	106	86
China Intelligent Lighting / CIL	2.12	29	82 3
China Cent Dragon Media / CCDM	4.80	41	89 4
ShengdaTech / SDTH	3.55	192	87 5
China Agritech / CAGC	6.88	143	67 6
China MediaExpress / CCME	11.88	438	69 7
RINO Intl / RINO	6.07	174	21 8
1. Trading restarted 6/15/11; 2 . Restarted 6/14/11; 3. Delisted 6/14/11; 4. Restarted 6/17/11 ; 5. Restarted 6/10/11 ; 6. Restarted 5/20/11; 7. Restarted 5/19/11; 8. Restarted 12/8/10. NOTE: all restarted stocks now trade OTC. Sources: Nasdaq, Bloomberg

Securities-lending is a big Wall Street business. An investor planning a short sale calls her "prime broker," who then locates borrowable securities from the broker's inventory, from another brokerage firm or from the huge securities lending operations of custodial firms like State Street or Northern Trust, who lend the shares owned by big institutions like exchange-traded funds. Rebate percentage rates are determined by supply and demand. Historically, halts rarely lasted more than a few hours, so agreements didn't anticipate months-long delays following fraud allegations that raise doubts about the validity of the frozen price.

The High Price of Success

Short-sellers of China MediaExpress stock had to pay interest based on the pre-halt price as the company appealed its delisting.

A veteran of the securities-lending industry sheds few tears for the burned shorts. "When those hedge funds make a lot of money, they are not looking to share those profits with other participants in the stock-lending food chain," he says. "Why would I bail them out? Because I'm a nice guy? Nice guys live up to their contracts."

A quicker resolution of trading halts would mitigate the problem of shorts, and longs, who want out. But Nasdaq affords listed companies a delisting-appeals process that can take more than 90 days. "While Nasdaq recognizes that a trading halt can disadvantage existing investors," says a May 23 note on the exchange's Website, "Nasdaq's primary regulatory responsibility is to prospective investors."

Hedge funds grumble that stock lenders aren't moving more quickly because they make more money this way. But prime brokers like Goldman Sachs have been pushing a possible solution. The mechanics, and new rules from Finra and the SEC, need to be ironed out. "A lot of people are feeling a lot of pressure about this situation," says an official at a large prime broker. "The relevant regulators are very much aware of the impact of this on short-sellers."