Last month we published a story on Longfin, a Nasdaq listed trade-finance company with a tenuous link to blockchain technology and hence an excessively high market capitalisation.

To recap, FTSE Russell decided to add Longfin to its Russell 2000 and 3000 small-cap indexes. Index funds then bought shares for their various products.

There was one problem though.

FTSE Russell had calculated the available free float of Longfin at 22 per cent, exceeding the 5 per cent required for its indexes, when in reality the number was closer to a diminutive 2 per cent.

Because of this error, BlackRock and fellow passive investment providers had aimed to accumulate roughly 1.1 per cent of Longfin, but ended up holding around 45 per cent of the entire free float.

Quick to realise its mistake, FTSE Russell announced Longfin would be removed from its indexes. The stock plummeted, with the error costing investors in FTSE Russell-linked products around $10m, according to Financial Times calculations.

It hasn't got any easier for Longfin since.

On April 6th, with its share price settling at $28 after lurching between $73 and $5 in the previous ten trading days, the SEC announced it had:

obtained a court order freezing more than $27 million in trading proceeds from allegedly illegal distributions and sales of restricted shares of Longfin Corp. stock involving the company, its CEO, and three other affiliated individuals.

We won't go into the gory details here, but the SEC accusation involves insiders selling large blocks of restricted, and unregistered, shares to the public, pocketing $27m in the process. Nasdaq, realising this was a bad look, suspended Longfin's equity from trading:

Quill Cloud

So why are we flogging this dead horse now?

During the share price meltup to the mid-$70s, savvy options traders decided to load up on 'put' options listed on Nasdaq and other exchanges in the expectation Longfin's share price would run into reality, and collapse.*

In case you aren't aware, a put option is a derivative which gives an individual the right, in return for a small premium, to sell a share at a specific price within a certain time. Often used to insure portfolios against the vagaries of markets, put options are essentially a way of betting that a security's price will fall.

Tomorrow, 26,951 of Longfin put options will expire, representing 2, 695,100 shares as each options contract is for 100 shares. In other words, the rights to sell account for 237 per cent of the 1.1m free-float as calculated by FTSE Russell.*

Our readers may be wondering why Nasdaq allowed the options to trade on its exchange, given the size of the market relative to the free float that FTSE Russell cited when removing the stock from their indices.

The answer is that Nasdaq calculates the public float differently to the index provider's definition of free float.

At the end of 2017, according to Bloomberg data, 85.4 per cent of Longfin's Class A shares were owned by two beneficial owners, including chief executive officer Venkat Meenavalli and his holding company Stampede Capital Ltd, which is traded on the National Stock Exchange of India. That leaves 6,790,789 shares owned by non-beneficial owners.*

Parsing the exchange's rules for which options are allowed to be listed, we came across this wording in Chapter IV:

There are many relevant factors which must be considered in arriving at such a determination, and the fact that a particular security may meet the standards established by Nasdaq Regulation does not necessarily mean that it will be selected as an underlying security. Nasdaq Regulation may give consideration to maintaining diversity among various industries and issuers in selecting underlying securities. Notwithstanding the foregoing, an underlying security will not be selected unless:

i. There are a minimum of seven (7) million shares of the underlying security which are owned by persons other than those required to report their stock holdings under Section 16(a) of the Exchange Act.

If this is indeed a hard and fast requirement, it means the float has to be at least seven million shares, not counting beneficial owners, defined by the 1934 Securities and Exchange Act as any shareholder with more than a 10 per cent stake.

Longfin's public float of 6,790,789 figure is a touch below the 7m mark, but above Nasdaq’s requirements for continued listing of options, which stands at 6,300,000 shares. So that perhaps explain why the options were traded up to the day of suspension.

What about the bearish traders and their valuable put options? Are they going to get paid when the underlying instrument has no price?

According to data from derivatives clearing house the Options Clearing Corporation (OCC), there are 4,889 Longfin put options expiring tomorrow which have a strike price of above $30 and are therefore, in trading parlance, 'in-the-money'.

In usual circumstances, if you have a profitable option trade and you forget to exercise it on the day of expiration, the OCC will kindly do the work for you.

However, there is a slight catch with options whose underlying shares have been suspended -- one has now to request to the OCC that the option get exercised. Let's hope Longfin bears got the memo.

*Update: We've updated the post with the correct figure for the share ownership of Mr Meenavalli and his holding company, and for the number of shares represented by the outstanding options. Apologies for the errors. We have also added the difference between Nasdaq and FTSE Russell's basis for calculation, and to clarify that Nasdaq is not the only exchange listing the options.

Further Reading:
Investors nurse $10m losses on LongFin index mistake - FT
FTSE Russell gets in a tangle - FT Alphaville

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