Monday, March 8, 2010

Dividends on shares sold short

What happens to dividends and special distributions when a short position is open?

While a short position is open, there might be a scheduled dividend payment by the corporation to its shareholders or a special distribution of any kind (cash, stock, spin-offs, etc.). In this case, there are three participants, the original shareholder (who lent you their shares), the short seller (you), and the new shareholder (whoever bought the shares you sold short).

It is important that you understand that both the new and the original shareholders expect a dividend payments since the securities lending agreement usually doesn't give away the right to dividend and distributions that the original shareholder had. This is different than voting rights since those are normally transferred from the original shareholder lending out the shares to the new shareholder who bought the shares that were sold short.

Let's assume there is a scheduled dividend payment. This is the position of each participant:
  • The original shareholder (with their shares out on loan to you) expects a dividend
  • The new shareholder expects a dividend (since to them, the transaction is no different than an outright purchase of stock)
  • The short seller is holding the short position.
And this is what happens:
  • The dividend paid out by the corporation goes out to the new shareholder
  • The short seller has to pay out the dividend to the original shareholder.
  • The stock will usually adjust its price down by the amount of the dividend, benefiting the short seller.
The same thing would happen with any other distribution made by the corporation to its shareholders. The short seller would have the obligation to make those payments to the original shareholder to mirror those that the corporation is making to all its shareholders.