Short on South Korea biotech company turns into $1bn trader nightmare

Traders and foreign hedge funds that sold short a small South Korean biotech company last year during the height of the coronavirus pandemic are set to lose more than $900mn after the stock’s price skyrocketed.

Short sellers of DIAC, whose trading was halted on the Kosdaq last March because of audit failures related to financial problems, are expecting losses after the company split and merged with its auto parts affiliate Dual through a share swap.

The short positions were worth about $13.5mn at the time of the stock suspension and had increased to $930mn as of last week, said traders. Less than five per cent of DIAC shares were held short when the stock last traded. Investors shorted the company because of uncertainty over the value of an anticancer drug it was developing in clinical trials.

But since the trading suspension, the stock’s value has jumped 69 times, while Dual shares have increased more than 1,500 times from Won107 to Won161,000 (US$0.09-$164) on the K-OTC market since September.

“The abnormally high stock price will make the short sellers pay dearly to settle the deals,” said the head of a local brokerage with knowledge of the situation.

The surge of Dual shares has fuelled concern among traders and hedge funds over potential stock manipulation and a lack of regulatory scrutiny of the merger.

They cautioned that the saga would have an adverse impact on Korea’s reputation among international banks as the country tries to win MSCI developed markets status.

DIAC’s market capitalisation reached more than Won20tn ($16.6bn) this week, more than that of LG Electronics and Samsung Corp, the de facto holding company of South Korea’s biggest conglomerate Samsung.

“The company’s large shareholders seem to be playing with the stock,” said Won-il Lee, a former hedge fund manager and now an ESG consultant. “But the strange trade has been left with no regulatory intervention for nearly a year. It shows how unfair the market can be. ”

Regulators approved the controversial merger this month after repeated delays over a lack of information provided by the company on the deal. Trading is expected to resume when the deal is finalised, with a first settlement date for short sellers tentatively set for March 11.

Under the share swap deal, one DIAC share will be exchanged for one Dual share. The latter stock began trading on the over-the-counter market in September before the merger and has surged since.

DIAC shareholders will be able to resume trading using the Dual shares they are given, but traders who shorted DIAC shares will have to return the borrowed shares in Dual shares and will be forced to buy them at much higher prices.

“Because of the mechanism, that is likely to cause huge losses,” said a foreign bank trader.

Dual said in its merger application that the company was under investigation by financial regulators but it remains unclear what the probe is about.

Officials at Dual and the Financial Supervisory Service could not be reached for comment.

Korea Exchange data did not specify which hedge funds were involved, and showed only Morgan Stanley as the main short seller on behalf of its clients. Morgan Stanley declined to comment.

Traders complained of a lack of protection for international investors. “I am not sure of any willingness at the moment to intervene to ensure the market is stable and operating with integrity,” said a trader at a global investment bank.

Last May, South Korea lifted a 14-month ban on short selling against blue-chip stocks during the pandemic. Traders expect regulators to lift the ban on smaller stocks as well after the March 9 presidential election, despite strong opposition from retail investors.

“It is a long shot because of these sorts of [short selling] regulations and lack of protection for international investors,” said the foreign bank trader. “No one wants to intervene this time before the election. No one wants to protect a short seller.”