Getting Caught Short
Liquidation of TFS funds is hindered by regulatory roadblocks.
By Bill Alpert
April 6, 2018 9:44 p.m. ET
After 20 years as investment advisors, Rich Gates and his partners at TFS Capital decided to close their West Chester, Pa., business last year. Gates had figured as one of the whistle-blowers in Flash Boys, Michael Lewis’ exposé of high-speed trading. But performance was poor in the mutual and hedge funds that TFS ran, Gates says, and investors lost interest. Now, the liquidation of the funds is being hindered by a problem that we thought Wall Street had fixed years ago.
At the start of this decade, Gates’ funds shorted some of the U.S.-listed Chinese companies that later turned out to be frauds. The stocks crashed, but even so, the short sellers lost money. That’s because they couldn’t close out their positions in the halted stocks, and therefore had to continue posting margin security and pay to borrow the shares—for months, sometimes for years. As we reported at the time (“Even Short-Sellers Burned by Chinese Shares,” June 18, 2011), these investors who had uncovered many of the frauds and made the correct bet, ended up owing millions to their own prime brokers’ stock-loan departments. For whatever reason, the brokers seemed in no hurry to fix the problem.
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.
To prevent these problems from hurting his funds’ investors, Gates says he moved the positions onto his firm’s balance sheet. Then he started petitioning the brokerage industry and its regulators to address the situation. Only one of his firm’s three prime brokers— JPMorgan —has tried to help, he adds. Gates won’t mention the other two. He has joined an industry committee that the Securities Industry and Financial Markets Association calls the Worthless Securities Working Group. It moves slowly.
As with our earlier story, no industry folk or regulators would talk with Barron’s on the record. A few noted that 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. Everyone pointed fingers at the SEC, whose rules forbid transactions in unregistered shares. The SEC didn’t respond to our query. “The biggest hurdle is that, as short sellers, we are unsympathetic,” says Gates. “It’s hard to get people to care.”
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