Illegal Naked Short Selling Appears to Lie at the Heart of an Extensive Stock Manipulation Scheme
Investment Consequences of Naked Shorting
Only a motivated enforcement agency with subpoena power and an accompanying powerful enforcement infrastructure can prove that naked shorting is at the heart of an extensive stock manipulation scheme. However, I believe that the observational evidence is overwhelming that naked shorting practices are widely used to manipulate the stock prices of emerging biotechnology companies as well as many other small and large companies. Unfortunately, naked shorting is an investment variable that investors must understand if they are going to make investments in the emerging biotechnology space in particular and the equity markets in general.
Investors may decide that they just won’t invest in companies that are most subject to naked shorting, but this would eliminate many small emerging growth stocks with exciting potential. For those like me who are attracted by potentially breakthrough technologies, you will inevitably get caught up in a manipulation that leads to a suddenly plunging stock price of a company in which you are invested. Invariably the scheme starts with and is perpetuated by a flurry of blogs, tweets and message board comments which proclaim that the technology is worthless; management is a band of liars and thieves; and people with a positive view on the Company are being paid by the Company. Then come the lawsuits against the Company and management by the usual group of class action law firms. Each year this scenario is played out hundreds of times.
This carefully scripted and long used manipulation scheme by short selling hedge funds is all meant to shake and then break investors’ confidence. The result is usually a painful, steady, day by day erosion of the stock price due to naked shorting practices. Stocks can be cut in half by naked shorting on the basis of little or no change in fundamentals. If you are going to invest in this area, you must decide when this occurs whether you believe strongly in the Company and can ride out the storm or want to cut and run. However, sometimes it happens so rapidly that the latter is not an option. On the positive side, these manipulations can often lead to some excellent investment opportunities if the fundamentals remain intact, investor confidence returns and the shorts are forced to cover.
The Rationale forInvesting in Small Emerging Biotechnology Companies; Is It Worth It?
I worked for many years on Wall Street as an analyst covering large pharmaceutical and biotechnology companies and rarely dealt with small companies which I arbitrarily define as having market capitalizations under $1billion. From my experience with these large companies, I came to believe that they were excellent at drug development and commercialization and sometimes innovation, but depended extensively on small entrepreneurial companies for their pipelines. Many, indeed most, of the paradigm changing technologies are initially pursued by small companies. The big companies generally wait for proof of concept and then swoop in to either license the technology and/or the drugs stemming from it or to purchase the companies outright. This can lead to some incredible homeruns for investors in small companies so much so that one success can offset several failures.
The behavior of the big companies is understandable as the number of intriguing and promising new technology approaches in drug development seems endless. I personally have done some tracking of over 300 biotechnology companies and this is not an exhaustive list. Moreover, exciting new technologies are evolving like lava flowing over the rim of a volcano. Even big companies lack the infrastructure and financial resources needed to aggressively pursue more than a small fraction of drug development opportunities. Once committed, the development costs for a new drug can run into the hundreds of millions and even over $1 billion of costs. And of course, the failure rate in new drugs is astronomically high. I have seen estimates that for drugs that begin human phase 1 trials, perhaps only 1 in 10 will reach phase 3 and in phase 3 a significant percentage will fail. And even of those that succeed only a few become blockbusters.
With this high rate of failure, drug development is not for sissies. Research people at large companies get rewarded for successes and fired for failures. Hence there is a tendency to focus on evolutionary (me too) drug development in which there is less risk and leave the paradigm shifting efforts to entrepreneurs willing to accept the very high risk of failure for the extraordinary rewards in those few cases in which success is reached. What are those odds for success? I have no data to back this up, but the chance for moderate success is less than 1 in 10 and for home runs is in excess of 1 in 25 or 1 in 50. Take these numbers as being representative of the risk as opposed to a well-researched estimate.
Wall Street analysts have risk profiles that aren’t that different from research people at big pharma. They gain fame for being correct on a stock and can lose their jobs if they take a risk on an unproven drug or technology and get “blown up”. As a result, many early stage companies are ignored by analysts or primarily covered by analysts working for investment banks who specialize in bringing such companies public; naturally analysts employed by investment banks are always positive on the stocks their firms underwrite.
As I looked at this situation, about five years ago, I sensed an opportunity to try to bring quality research to some of the companies in this vast universe of poorly followed companies. Obviously, it is not possible to cover all possible companies so I focused on just a few in which I tried to do exhaustive research that could give me an edge. My strategy was primarily although not entirely to focus on stocks that could be homeruns. (Please refer to my earlier comments on the risks involved). Recognizing the high potential for failure, I tried to find as many opportunities as possible and never put all my eggs in one basket. In my own portfolio, I invest in a large number of early stage biotechnology stocks as I fully recognize that I am going to be wrong in a significant percentage of the stocks I deal with. I call my strategy asymmetric investing and this is explained in more depth on my website at this link.
Finding Out About Naked Shorting
I started developing my website and its content about four years ago. As I gained more experience, I was startled to find that there was another very important force at work on these companies that was apart from the fundamentals that I was focused on. One would expect a high level of volatility in the stocks in which I specialize. However, this could not always explain the demoralizing collapse of a meaningful number of stocks that I am involved with following some news event. Suddenly and without a major change in the fundamental outlook, I would see stock prices cut in half in a short period of time. During this time there was invariably a steady day by day price erosion (naked shorting at work) accompanied by an unending stream of contrived negative news flow that was demoralizing to me and other investors.
In order to give more insight into what a naked shorting attack might look like, I have put the predictable elements of a typical attack based on my experience in living through a number of them on separate companies.
Shorts like to target emerging biotechnology stocks that are engaged in high risk drug development and are not widely covered by quality research analysts. The initial and subsequent attacks are almost always triggered by some news event. Obviously, the shorts seek out negative news or an event that creates uncertainty. However, sometimes an attack can be based on a positive news event which the shorts spin to make it appear negative. Using the ready platform afforded by the internet and social media, a blogger associated with the shorts goes to work with a negative interpretation of an event. These are usually not sophisticated analyses and are usually limited to one or two pages of text which is invariably one-sided and unbalanced. These are meant to provide “intellectual” reasons and cover for the short attack. The most prominent of these bloggers usually have no backgrounds in biotechnology analysis or expertise in the science. I believe that in many cases, hedge fund employees actually write the articles which are cut and pasted into the comments of these bloggers. The heart of the naked shorting scheme involves a group of hedge fund traders conspiring to steadily knock out offers for the stock and to trigger stop loss orders (This is explained later in this report). This is called walking the stock down. The power of these conspiracies is striking and in many cases allows the shorts can largely determine the price that they want the stock to trade at. The stock weakness gives legitimacy to the contrived negative blogs. The idea is to create fear and uncertainty among investors by making all news events appear to be negatives and to fabricate new issues that the shorts hope will demoralize investors. The first time I came up against this, my thought was that the blogger was someone who was just more cynical about the chances for success and had an opposite point of view from mine. This is understandable and common in research analysis. I wrote a respectful rebuttal to their argument. I thought that after their rebuttal to my rebuttal, this would end the discussion. We had expressed our opposite points of view, would respectively disagree and move on. This had mainly been my experience in my Wall Street days as an analyst when I disagreed with another analyst. I was wrong. The situation quickly escalated. In the rebuttal, the blogger accused me of being stupid, deceitful and being paid by the Company to write positive comments. In this case, over 20 articles were then written in a period of a year. Usually, they were timed to a press release and regardless of the news and without exception each was interpreted as a major negative. A major strategy was to argue that management was lying to investors and manipulating the stock. The stock would go down on good news, bad news and uncertain news. One of the pillars of stock manipulation is to make good news appear to be bad. The blogger was indifferent to truth and actually would make up information that was factually incorrect. When made aware that the information was wrong, he/she would ignore it and even repeat it in later blogs. There are a number of bloggers who participate in these attacks. Many of these bloggers appear to work together and coordinate their negative attacks. It is striking that many of these people have connections to one another. Many of them were trained at a well-known blogging site that was founded by hedge fund people. Sophisticated use is made of the Internet and social media. Twitter is used to signal that an attack has begun. Shorts are well connected to mainstream media and are adept at getting them to unwittingly participate in the scheme. Vicious attacks are launched on writers who might have an opposite but hopefully more well-reasoned and balanced view. The usual line is that they are being paid by management to write positive articles. Seeking Alpha has become very friendly to articles supporting short selling and is used extensively by the hedge funds. The site actually promotes as one of its favorite authors a person who writes only negative attack article on companies in which he claims that managements are lying and paying authors who have a positive view on the Company. In his disclosure, he states that he shorts stocks, then publishes a negative article on Seeking Alpha and states that he may cover immediately after the article is published. This seems to meet the definition of a pump and dump scheme. He also acknowledges that he is collaborating with other short sellers. I think they contribute the information for most of his articles Seeking Alpha allows articles to be published by anonymous authors. These articles are often extremely bearish and are almost certainly written by people at hedge funds. Hedge fund create pseudonyms and publish on a daily basis negative comments on message boards like Yahoo and Ihub. Law suits appear after articles and allege misconduct on the part of managements and urge investors to participate in a class action lawsuit. Initially, I attributed these actions to people who were just more cynical than me and honestly came to their bearish views. I am also very cognizant that there is not an insignificant amount of stock manipulation that warrants shorting some stocks. There are some bad actors who pump stocks up and then dump them and this is every bit as egregious as naked shorting attacks. Interestingly, I believe that the hedge funds who short can be enthusiastic participants in these manipulation schemes as well. I also understand that managements can and usually are over enthusiastic in presenting the outlook for their companies. They have so much personal wealth and intellectual effort invested in a Company that objectivity can be difficult. I also have to admit that I have a bias toward optimism largely stemming from the belief that we are in a scientific renaissance in biotechnology that will lead to a meaningful number of breakthrough drugs and accompanying home run stocks. I recognize this personal bias and try to adjust for it, but I am only human.
The above paragraph shows that not all of the investment land mines can be attributed to naked shorting. However, it seems to me that many are. Initially I thought that what I now believe to be naked shorting stock manipulation was attributable to market forces. The catalyst for my changing my view was coming across a shocking You Tube commentary by Jim Cramer of CNBC fame. He explained in detail how as a hedge fund manager, he participated in schemes to manipulate stocks. If you haven’t seen this it is a must watch.
This was a wakeup call for me and for the last few years, I have been doing a great deal of work on naked shorting. As I talked to companies, I heard the same stories over and over about techniques used to drive down their stock prices and I came to believe that there was manipulation going on and that it was extensive. The names of hedge funds leading the attack kept coming up in situation after situation. It has been my intent to write an article on naked shorting, but this is an enormous project and while I think I understand the effect that naked shorting can have on stocks, I lack the understanding of the trading techniques used to implement what is essentially an illegal stock manipulations scheme.
