What happens if a short position can't be covered?

Question

This question does a nice job of answering what it takes for short position to exist in the first place, how that can result in "owning" >100% of a company and what happens when shorters try to cover their short position with limited liquidity (i.e. how a short squeeze develops).

What I'm wondering is the different question (which I tried to ask here, which was closed as a dupe of the first): what happens if short sellers are somehow required to cover their position (i.e. required to buy at any price) but where there are NO shares being offered regardless of what price is offered? Every single last share is held by someone either unwilling or unable to sell it.

The details of how to construct such situation are not very relevant so I'll try not go into them.

Note:

It's possible the answer to my question is, "it's never happened, the law and regulators never considered it and until/unless it does happen, there is no way of knowing what would be done." If that's the case, then "oh well, maybe it would be fun to write a fiction book around that". But I'm kind hoping that someone knows something more definitive.

Answer 1

You've gone from A to Z, skipping all the letters in between.

In order for every single last share is held by someone either unwilling or unable to sell it, someone has to acquire a lot of shares. Shareholders who acquire more than 5% of the outstanding shares of a security must file a 13D or 13G form with the SEC. This is public information and the acquirer's intent is known. As the he acquires more, it becomes harder to borrow the stock for shorting, the borrow rate also increases and share price increases, all discouraging shorters and affecting their willingness to remain short. Some shorters close their positions. You don't go from a high number of short shares to no shares available to buy in one fell swoop.

And even if the acquirer buys enough shares to control enough shares to approach what you are describing, there are always some outsiders willing to sell their shares at a higher price.

Answer 2

In reality, sooner or later the people holding the shares will offer to sell them and rake in a big profit.

The thing about short squeezes is that sooner or later a shareholder will decide it's the right time to sell. At that point, the short squeeze starts to unwind and the share price will drop back to where it should be.

If you are that person who sells at the peak, you are the one who gets the biggest profit, and maybe you can buy the shares back again one the price has fallen back. If you are the person who refuses to sell, then you miss out on the chance. You watch your shares climb in price to dizzying levels, then drop straight down again, leaving you back where you were before.

Answer 3

What you are describing is called a corner. Disclosure laws have made them, at best, rare. I don't think there have been any successful corner attempts in the capital markets since the laws were put in place. It is still, at least in theory, possible to corner commodities markets. The commodities markets don't just permit insider trading, the law assumes that it must happen. When you combine that with a lack of disclosure laws, it is not impossible for it to happen.

As a practical matter, it would have to happen from a sequence of mistakes. For example, to actually buy every share would require a tender offer. The law requires specific disclosures to do what you are asking about.

The person that was short would have to be in a coma, for example, to not exit such a position. If the tender offer was successful and the goal was to buy all shares, then short-sellers would be scrambling to exit their positions. In such a case, it is likely the broker-dealer would close the position if the client didn't since there would be no available shares to short once the firm is no longer public. If the seller does not act, the broker will.

I will describe how it could happen, but how it would be resolved is unclear.

The person with the short position would have to be clueless or incapacitated after the start of the short position. There has to be something to prevent the person from closing the trade.

The broker-dealer would have to have a major software error. A hardware error would not persist long enough. Something would have to happen to segregate the one affected account in such a way that nobody knew it existed.

The regulatory oversight elements of the broker-dealer would have to break down as well.

All of that would have to persist until the tender offer was complete.

The open question is what happens to the party that loaned the shares. For example, assume that I own the 100 shares of ABC corporation and my broker shorted it. If I wanted to tender the shares, then I would be paid in cash out of the broker's pocket at the tender price. The holder of the short would come up with the cash.

On the other hand, assume that I own the 100 shares of ABC corporation and I want to be a minority shareholder. That is where the problem would come in.

My guess is that some form of binding arbitration would take over built around my estimation of the value of the firm. As long as my price is within reason, I would probably get it and the short seller would pay it. However, I don't know.

It is important to remember that if you and I form a group and we plan to buy the company up in pieces, then under the law we are considered a single buyer and all of the disclosure laws with their criminal and civil penalties kick in. It is against the law for a group of people to try to do this unless they disclose to the world what they are planning and how they are planning to do it. If they did, it would defeat the purpose of the group.

A short position is a loan paid in stock. Contract law provides a remedy for a contract that cannot be fulfilled.

There are other ways it might happen, but they all require negligence and systematic mistakes. The remedies would vary depending on the specific course of events.

Again, disclosure laws make what you are describing difficult because a person in a position of control, such as a 5% shareholder, cannot make swing profits. Any swing profits must be forfeited to the US Treasury. So, for example, imagine that I buy 10% of ABC company today, causing a short squeeze. I cannot sell any shares for six months unless I want to forfeit my money to the Treasury. It is against the law for me to profit from causing a short squeeze. Nor could I tell anybody of my plans because if I did, then it would be insider trading for them because I am a control person.

So, if you want to plan a squeeze, it is against the law for you to profit from it unless the squeeze lasts for six months or more, which it won't. Other people, that do not know you, can profit from the squeeze, but you cannot.

That limits the desire to corner a capital market.