When to Cover a Winning Short

You have sold a stock short and determined, based upon sound analysis, that the company is bound for a sad end -- anything from a significant drop to eventual bankruptcy. But remember that sad is happy when you are short. Even though it sounds like one of those aphorisms in Orwell's 1984, like "Freedom is slavery,"  sad is happy for a short position.

But let's explore the actual logistics of this success. It is never a certainty that a company will wither, let alone die, but for the sake of argument let's accept the downside as fact. Are there any reasons to cover the short rather than wait?

This actually is relevant to us. One of our short positions, Sirius Satellite Radio (Nasdaq: SIRI), has fallen precipitously -- from our short price of $6.90 to yesterday's close of $0.75. The company has proposed a reorganization that will dilute current shareholders massively (which we like, since we're short), but the odds favor bankruptcy sooner if the reorg isn't approved or later even if it is. There's no certainty, but let's say there were, and you don't currently need the money to deploy in a better investment elsewhere. Are there other reasons to cover?

I am not a tax accountant or a tax lawyer, but I did email with Roy Lewis (TMF Taxes) and Motley Fool Community member howardroark. They were very helpful, as are all Motley Fools! Distillation follows. As with any financial material you encounter, do not rely solely on what you read. Even though we all speak authoritatively, of course.

What if it's going to zero?
Even companies on the way to death may take some time to arrive at the Grim Reaper's House o' Bankruptcy (Where the creditors fight among themselves rather than with you, the debtor. Sweet!). In the most familiar cases, such as Enron or WorldCom, the stock begins to drop. And drop. And then the ticker gains a "Q" after the name, and trades for pennies. Remember WorldCom in July?

And a stock can roll around under $1.00 for a long time. If your share price falls below a dollar for 30 consecutive business days, the Naz sends you a letter, warning that you will be delisted if you don't boost it over $1.00 for 10 consecutive business days of the next 30. That strings it out, as can appeals, requests for extension, intervention by the Naz higher-ups, and so on. 

Meanwhile, many dying stocks restructure, buy back shares, or effect a reverse split to boost the share price back over the $1.00 limit. (Be warned: Some academic studies have shown that a reverse split simply delays the eventual demise.) If you'd like to review the fine print on Nasdaq listing criteria (which it is reportedly reconsidering), an excellent 2000 article appears on the Holland & Knight law firm's website.

Even if and when a stock is delisted from a major exchange, it can still trade on the Nasdaq's Over the Counter Bulletin Board, or the National Quotation Bureau's Pink Sheets. On Feb. 15, 2002, satellite telecom provider Globalstar filed for reorganization under Chapter 11 of the Bankruptcy Code. Its shares closed yesterday at $0.12. Shares of auto logistics fraud ACLN, now trading on the Pink Sheets for $0.10 a share. How do I know? I was once long both of these stocks, and learned lifetimes of lessons therefrom.

So even in the worst cases of a company currently in bankruptcy reorganization proceedings but before bankruptcy discharge when the court gives you the official discharge from most prior debts, or where the evidence suggests strongly that a company has been criminal, shares can still trade for some time. That gives the short seller the ability to time the covering transaction.

The lyrical tax code
With a short, you will pay taxes at the short-term capital gains rate no matter when you cover, so you don't gain anything by keeping your short open any length of time. However, in general it is better to put off paying capital gains (or any) taxes, because inflation means that a fixed amount of money is worth less tomorrow than today. However, if you expect deflation, you might want to pay the taxes today because they will be worth more tomorrow. Sustained deflation is extraordinarily rare, though not unheard of.

The only benefit seems, then, to be in deferring taxes. Given that there may be a market for the shares even if delisted and before bankruptcy discharge, how long can you defer taxes by keeping your short position open?

Section 1233(h) of the Internal Revenue Code states:         

 If --
(A) the taxpayer enters into a short sale of property, and
(B) such property becomes substantially worthless,    
the taxpayer shall recognize gain in the same manner as if the short sale were closed when the property becomes substantially worthless.

You can defer recognizing your gain on a short sale until the shares become "substantially worthless." Well, when the heck is that? Things are either worthless or not, aren't they? Ah, tax law.

What's "substantially worthless"?
Is it when a company files for bankruptcy? According to Roy Lewis' reading of the tax cases, "A corporation's filing for Chapter 11 bankruptcy reorganization does not quality as a 'fixed and identifiable event' establishing the lack of potential value." Fine, but reading between the lines tells you that there is at least a theoretical possibility that, while the filing may not be "fixed and identifiable," it could be part of a larger determination of "substantially worthless" considering -- another great legal wiggler -- "all the relevant factors" or "the totality of the circumstances." 

Help! Now you know why I got lower grades with each tax law course I took. That's why, Roy says, why not cover when you can control the situation and not have any argument with the IRS about when a position becomes "substantially worthless"? Indeed. I don't want to argue with the IRS about anything.  

The other point of view is that, as long as there is a market for the shares, they are not "substantially worthless." Under this view, the shares are worth less than the paper they are printed on 99% of the time that a bankruptcy court issues the discharge to a debtor.

In those cases when the company is reorganizing under Chapter 11 (like Globalstar plans to), as opposed to liquidating its assets under Chapter 7 (as did wireless service provider Metricom), a company's creditors receive the new equity in the new company and shareholders of the prior company get nuthin'. They are wiped out. Under this interpretation, it would appear that you can defer the taxes until the bankruptcy discharge.

But even under the latter view, things are never that simple.

Should you cover earlier?
Are there other reasons you might want to cover? howardroark raises a few points. First, if you expect the short-term capital gains rate to increase, you want to pay your taxes under the current, lower rate, so cover now.

Also, if your stock pays a dividend, you may not want to keep paying the dividend each period (a short seller is obligated to pay the dividend to the person who lent the shares -- don't ask me how it works, but it's true). When Greenlight Capital publicized its short position in Allied Capital (NYSE: ALD), which pays a substantial dividend, the cost of paying that dividend quarterly certainly must have been (or still be) a consideration in how long to hold the short position. Finally, you might not want to pay the borrowing costs anymore (you short on margin), but as the stock price declines, you have lower and lower margin interest expenses.

One last note: According to howardroark, the IRS doesn't permit you to cover a short in December to settle in January, deferring the capital gains tax to the next year.

There you have some considerations. Apply them to your own situation as they fit.

Leafing TREE
By the way, LendingTree (Nasdaq: TREE) announced last week that its Q4 EPS would be $0.18, 80% more than the $0.10 previously forecast, as low interest rates drove borrowers to its online lending exchange in search of better home first mortgage, home equity, auto, and consumer loans from the exchange's myriad lenders. The stock shot up about 25% over three days, probably due to the combination of the good news and some covering by short sellers -- an astonishing 53% of the share float is short, with seven days to cover at current average daily volume.

Fine. But what bothered me was that the company felt a need to project a 70% compound annual growth rate (CAGR) in EPS through 2007, hitting $2.00 a share. Any management should just zip it -- whether it's eBay's (Nasdaq: EBAY) calm, matter-of-fact CEO Meg Whitman or LendingTree's far-from-humble Doug Lebda. 

Sure, confidence is a good thing, and LendingTree folks have a reason to crow, fixing their balance this spring and going from near-death last fall to bloomin' success a year later. But why the forecast? It's like pulling a Gary Hart, "Catch me in an infidelity if you can!" Why not just build a great business, and let the stock price take care of itself? If you're hyping the stock, why? Scare the shorts into covering? Who cares? Stick to your knitting, er, online lending exchange.

I will end with this today: Can you believe Amazon's (Nasdaq: AMZN) stock price over the last year? Updated portfolio returns below, showing that the port is ahead of both the S&P 500 and the Nasdaq for the month and year. Have a most Foolish week!         

Tom Jacobs (TMF Tom9) wants to live in one of those abodes on the House and Garden Channel's Extreme Houses show. He and the Motley Fool investment analysts present interesting companies for you -- including the occasional juicy short possibility -- every month in The Motley Fool Select. Enjoy your 30-day free trial today! At press time, he owned shares of LendingTree.  To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.

Rule Breaker Portfolio Returns as of 11/25/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week       5.12%      3.61%    --       6.33%
Month     12.09%      5.32%    --      11.45%
Year     -16.86%    -18.74%    --     -24.02% 
CAGR 
 using IRR**
 since 
 8/4/94*** 21.45%      8.48%    11.35%   8.28%
10/20/98*** 3.87%     -5.86%    -2.53%  -6.94%