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On my last note, a reader commented:

Stop loss usage is not recommended in biotech stocks!! Those that use it IMHO are wrong!

Other people expressed consternation about market manipulation:

Why isn't there one good article exposing MM manipulation of the stock?

As we saw today in Vivus (VVUS) and a few weeks ago in Arena (ARNA), sometimes market participants will drive down the prices of some of the biotech stock as much as 50% in what would seem to be a stop hunt (basically triggering stop loss orders). In my case, the shares were funded solely out of profits from the stock itself (I traded VVUS in the 22-25 range and sold most of my outstanding shares at 28, derisking my initial investment and keeping the rest in profit), so I try not to pay too much attention to these activities - and keep no stops whatsoever.

The first article stemmed from my frustration at what seemed like shenanigans played by the financial media. In the second, I discussed how I approach the large events, and following the advised strategy would allow you to completely ignore the machinations. But it is truly sad that no one really tried to discuss price manipulation.

I was going to avoid this topic. But a recent rebuttal really needs to be picked apart.

The blogger in question repeatedly attacked certain stocks and pumped others. The situation reached a boiling point and resulted in a cease and desist letter [pdf].

But let's analyze the arguments from his defense:

It first starts with an ad-hominem attack:

But recently, a public watchdog group in Washington with no expertise in financial markets took the unprecedented step of demanding a criminal investigation of a New York hedge-fund manager simply for engaging in short selling biotech stocks.

Let's actually go through the letter. The demand for investigation is not merely for shorting biotech stocks but engaging in highly unusual and suspect practices. In one example, the manager "asked to be included on a panel discussion on Arena Pharmaceuticals' weight-loss drug Lorcaserin" and requested to be taken seriously even though the gentleman explicitly admitted that he is not "an expert in medicine or biological sciences". It should be obvious that the panel discussions should only include medical experts, not financial analysts or anyone who probably couldn't give a reasonable assessment. It just does not pass the smell test. There is a big difference between shorting and engaging in ethically and legally questionable practices, and it is perfectly acceptable to investigate if the latter happened.

They own stocks and resent short sellers making a case for why the stock they own is overvalued.

No one resents the arguments of short sellers. You are entitled to discuss why you believe that a drug will fail. Adam Feuerstein very liberally attacked ARNA back when it was $2.50, asserting his belief that lorcaserin wouldn't get a nod from the panel. However, it crosses into fraud/manipulation when those opinions are treated as fact and carried on news networks as if they are authoritative statements.

Smart, experienced long investors, however, value learning from someone on the other side of an investment.

David Einhorn is the perfect example of a short-seller. He has a thesis, and makes it clear when he shorts. He doesn't resort to manipulating companies or regulatory panels. He observes, sees inconsistencies, and shorts. His talks actually do bring value. On the other hand, the practices of the aforementioned hedge fund actively sought to disrupt company function. Einhorn doesn't have to destroy Green Mountain (GMCR) trucks in order to make money, and no biotech investor should have to mess with the FDA process in order to make his view pan out.

The back-and-forth exchange works both ways.

A back and forth dialogue is desired; an active sabotage is not.

What troubles me, however, is the growing propensity for less confident long-only investors to attack the messenger -- short sellers like me -- instead of rigorously debating the short thesis.

Attacks like those on the aforementioned hedge fund are attacks on the practices, not the arguments or ideas.

Short sellers 'attack' and must be stopped while investors (a euphemism for long-only buyers) are almost always characterized as being virtuous and good.

Naked short sellers do attack. When you short-sell without locating shares, you are increasing the float (suddenly there are more shares outstanding than issued by the company) and, in a positive feedback cycle, actually reduce the per-share price. We saw a similar situation with (OSTK) back in the dot-com bubble. There's nothing different.

No thought is given to the possibility that the short thesis might be correct.

If the manager actually engaged in discussion, then we wouldn't have this discussion. There are many vibrant discussions here and elsewhere, and so long as we stick to the purview of facts there are no problems. It's when the short sellers manipulate shares (for example, by naked shorting) that we have problems.

The Justice Department and the Securities and Exchange Commission are urged to launch investigations into short sellers simply because they short stocks --- legally.

Technically, abusive naked short selling is illegal. There's no evidence that the funds in question bothered to do locates. It should be simple to produce that log. some long-only circles, any negative opinion on a stock aired publicly is automatically considered to be manipulation.

Manipulation comes when people who are perceived to be presenting news are actually presenting opinions. They are fundamentally different concepts.

Attempts to discredit an opinion by attacking the legitimacy of the source are only persuasive on a superficial level.

You are confused. What we are seeing are attempts to discredit an article which tries to represent itself as news when it is opinion, which is a perfectly legitimate attack.

Who wants to make their bearish view public if it means having to defend oneself against litigation, no matter how frivolous, or a government investigation, no matter how politically motivated?

You have to defend yourself against litigation if you engaged in illegal practices, some of which were discussed above.

Short sellers serve a vital function in our capital markets.

They effect efficient price discovery despite our regulators' best efforts to impede price discovery when stocks move down.

They do, but only insofar as they take the opposing view. When people from either side, long or short, attempt to cook books or manipulate regulatory processes, a "vital function" turns into "manipulation."

Does anyone seriously think we will see a downtick rule when stocks are up greater than 10%?

Actually, we saw stock halts in hospital stocks like Tenet Healthcare (THC) and Community Health Systems (CYH) after the supreme court ruling.

The reality here is that many parties are explicitly engaging in practices which are questionable in nature, and seem to think that any attack on illegal practices is an attack on the very nature of short-selling. No one, especially not me, believes that short-selling by itself is illegal or wrong. What's wrong is when people naked short sell or try to sabotage a company through practices that don't pass the smell test.

So I pose the following questions:

  1. Can you explain how ARNA's stop hunt on June 22 2012 is "price discovery"?
  2. Can you explain how the practices outlined in the complaint are legal and ethical? Some don't pass the smell test, and some don't seem particularly legal.
  3. Can you explain how naked short selling is somehow adding value and not just diluting the company?

As a coda, it should be noted that this doesn't just happen in biotechs. Phil Falcone of Harbinger Capital was charged with securities fraud when, amongst other things:

After he took control of an entire issue of high-yield bonds, Falcone kept buying with an eye toward rigging the market and punishing short sellers to settle a score. In the process, Falcone hijacked the market for the bonds and illegally manipulated their price and availability.

Falcone realized there was naked short selling going on, so what he did was buy shares and put them in a place that couldn't be re-lent to the short-sellers. So the SEC clearly said it is legal to naked short-sell but it is illegal to buy all of those shares? I'm not surprised to hear that "retail" participation in the equities markets are falling: If the regulators aren't actually addressing the problems, and are explicitly siding with scofflaws, why should people play in the markets?

So, recommendations: As usual, if you have an outsized profit in ARNA or VVUS, sell enough shares to cover your cost basis. Then just sit there and wait until the market reflects the true value.

Source: How To Think About Small To Mid Cap Biotech Firms: Market Manipulation, Stop Losses And 'Stop-Hunts'