Longfin’s Over-The-Counter Punch: A $1 Billion Short Squeeze?

Shares of Fallen Star Surge in OTC Trade Despite SEC Suit, Debt Default Event

After many had concluded Longfin Corp.’s stock-price trajectory couldn’t get stranger, it just did. But before expecting any sustained rally, investors should take a closer look at the books.

Shares of the financial technology company, which relisted in over-the-counter (OTC) trade on May 25 following its delisting from Nasdaq, have rocketed higher in recent sessions with no news or change in fundamentals. After rising about 40% on Wednesday alone, the stock trades at nearly three times its December IPO price and has a market capitalization of $1.1 billion. The company didn’t respond to a request for comment.

Here is some context on why such a valuation appears to defy gravity. The company’s shares took off just after its IPO when it bought a cryptocurrency company with no revenue called Ziddu.com, sending its shares as high as $142. For a while, the crypto-rally kept the stock in the stratosphere as investors sought bets on digital currencies.

But in late March, things fell apart: A number of prominent short sellers made public attacks on Longfin; the company’s shares were added and then days later removed from the Russell 2000 Index; and finally, the SEC launched an investigation, which was followed by an outright suit filed in the Southern District of New York and a trading halt. The legal proceedings are ongoing.

In spite of all that, the company was able to relist as an OTC stock on May 25. According to company filings, one reason for the decision was that its extended trading halt constituted an event of default, and the relisting was “an effort to mitigate the effects of the…default.”

Indeed, as we described in detail in this April report, the company is running out of cash – and fast. It collected just $3.7 million in cash from its $52.7 million financing deal announced in January. That deal, which includes a large amount of convertible bonds, is critical given the company had just $4.4 million of cash at the end of the first quarter. The company said last quarter that it “is unlikely that additional funding will be forthcoming pursuant to the Note Financing in light of the Default Notice.”

The bottom line is that the company, which had negative $1.8 million in operating cash flow last quarter, is unlikely to survive for long without a financial bailout. Longfin itself said in its most recent quarterly filing that “the continuation of the Company as a going concern is dependent upon the ability of the Company to obtain the monies from the Note Financing and the attainment of profitable operations. These factors, which are not within the Company’s control, raise substantial doubt regarding the Company’s ability to continue as a going concern.”

So what’s behind the stock-price move? The most likely explanation is a dramatic short squeeze – a rare event that occurs when investors are actually forced to return shares they’ve borrowed to sell short. Such an event creates a vicious cycle because short sellers watching their positions go against them get pressured to buy back stock and cover positions.

Consider the data. On May 31, some 1 million shares, or 26% of the share float, were sold short, according to IHS Markit. But in recent days, the total has fallen to just 6.5% of the float.

Such a dramatic decline in short interest was paired with a reduction in the number of shares available to short. The stable supply of shares declined by about 600,000 shares since the stock began trading over-the-counter, IHS Market estimates. When too many shares are held in accounts that don’t lend stock, it can become impossible borrow them.

“The price action is reflective of forced covering, as shares have been recalled with no alternative borrow sources available,” says Sam Pierson, Equities Analyst at IHS Markit.

Of course, short squeezes only last for so long. As investors who own stock realize it’s incredibly lucrative to lend them out, the market should return to equilibrium. “We may be getting close to the end of the short squeeze and some of the shares which were purchased in the last couple of days will start to be made available as new borrows for short sellers,” Mr. Pierson says.

The latest chapter of Longfin’s story offers multiple lessons for investors. First, be sure to recognize obvious risks that companies may keep hidden in filings, such as Longfin’s risk of losing its financing and being forced to fold. But it’s also important to realize that technical dislocations can happen to stocks that trade thinly over-the-counter, such as the latest move in Longfin.

To be clear, the bizarre tale of Longfin isn’t the fault of Regulation A+, which was simply a vehicle that allowed it to go public. The bad behavior happened after the stock was listed on Nasdaq and overseen just like any other company. The real culprit here is Longfin itself – which is far more likely enjoying a temporary short squeeze than a return to glory.

 

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