What the heck? Why does this even need to head to litigation? I'm sure these were OTC, but even so... how can MS just back out? http://www.finalternatives.com/node/18169 Hedge Fund Sues Morgan Stanley Over Canceled Sino-Forest Options Sep 23 2011 | 12:40pm ET A hedge fund is suing over its investment in Sino-Forest Corp.âand it isn't Paulson & Co. Hong Kong-based Oasis Management wants C$9.5 million from Morgan Stanley, which it said failed to settle put options on Sino-Forest shares that Oasis bought three weeks before a short-selling hedge fund's scathing report on the company sent Sino-Forest shares plummeting. Morgan Stanley claims it terminated the options because trading in Sino-Forest shares was suspended, but Oasis alleges that the bank did so to "limit its liability." Sino-Forest shares fell more than 70% in June after the Muddy Waters report alleged that the company overstated its timberland holdings. That swoon cost several hedge funds dearly, notably Paulson, which lost more than US$500 million on its huge stake in Sino-Forest. According to Oasis, it bought options to sell Sino-Forest shares for C$19 million on May 12. On June 2, Muddy Waters published its report, sending shares down to C$5.22 over a two-day period; they have not recovered. Oasis said that Morgan Stanley offered it C$3.8 million to cancel the options, which the hedge fund paid the bank a C$770,000 premium for. Oasis, which filed the lawsuit in London in July, wants C$7.5 million to settle.
Here lies the danger of non-standardized, non-centrally-cleared securities -- even institutions get scammed. If someone is trying to sell you something (particularly if they are the exclusive counterparty), one should be very cautious. If all such trading were forced onto open-competition exchanges, it would make things far more transparent and liquid. Why anyone would trade otherwise (whether a retail forex trader or MS bespoke derivatives institutional client) is a complete mystery to me.
You know... if the client just purchased naked puts without an existing long position... then arguably, it doesn't have stocks to sell to MS at that price. It can't deliver. And perhaps MS is saying, we can just settle this by assuming you could buy the stock at the last traded price for delivery... while the client wants the underlying marked at zero? Perhaps its not as clear-cut as I thought originally.
This does appear to be the problem, but not knowing sino-forest there must have been a very large seller getting out of it entirely, and maybe whoever that fund was might even be bigger than paulson&co.
Oasis has bought the right to sell shares of Sino Forest at some strike price. Morgan Stanley says, "Fine, sell me the shares, sucker!", which can't be done because the stock is non-trading and Oasis, not actually owning any shares, would first have to buy them. So... what would happen if you had exchange traded puts on some stock that goes into non-trading status? There is no longer a price on the stock, so how are the puts valued?
Most likely they'll have to resort to book value, but they could do some fudging and say in the past it traded here so it must be worth this much. I didn't think OTC options should ever have this problem.
A lot of OTC options have a clause about the counterparty (bank)'s ability to hedge. If MS can't hedge their position (short more stock against their short put) then they could trigger a cancel and pay scenario... MS makes up a value for the option and it is automatically closed out at that price.
I am pretty sure MS is invoking the loss of borrow clause, it's pretty standard for large OTC option deals. Loss of borrow covers halt of trading too, so I would recon MS is in the clear on this one.