Moral hazard is observed in any decision-making entity – including individuals, corporations and even government regulatory agencies – and in extreme cases helps to explain many of their otherwise inexplicable actions. Indeed, when attempting to understand much of what happens at the Securities and Exchange Commission (SEC), I believe moral hazard is nearly as important a factor as the much more frequently-discussed matter of regulatory capture.

The following case illustrates this quite aptly.

In his most recent report to Congress, David Kotz, Inspector General of the SEC, summarized an internal report prepared by his office in which two unnamed enforcement attorneys were found to have provided information on non-public SEC investigations to an unnamed short-seller and an FBI agent. It’s apparent that the short-seller and FBI agent are the infamous Anthony Elgindy and Jeffrey Royer, respectively. The identities of the two SEC investigators who enabled them, on the other hand, are not clear.

Hoping to learn more, longtime SEC critic Dave Patch requested and received the IG’s full report on the matter (get your copy here!). Months later, the report arrived, though redacted by SEC censors (not affiliated with the IG’s office) to the point of near incomprehensibility. None the less, thanks to a single missed redaction and extensive cross-referencing of facts mentioned in the report, we’ve established the identities of both SEC employees.

They are: Douglas Gordimer and Robert Long, both senior investigators at the SEC’s Fort Worth regional office. Knowing this, it’s possible to fill in almost all of the holes left by SEC censors, and better understand the enabling role that organization played in the Elgindy/Royer scams.

It all began in March of 2000, when Royer, then a special agent with the FBI’s White Collar Crime Unit, contacted Gordimer about Broadband Wireless (BBAN), a public company Royer was investigating. We know from other sources that Royer would later inform Elgindy associate Derrick Cleveland of the subsequent SEC investigation into BBAN, and that both Cleveland and Elgindy illegally (and profitably) used that information to short the company’s stock ahead of the investigation’s disclosure.

The BBAN situation apparently gave Elgindy a really bad idea: to use Royer as a conduit for acquiring negative, confidential information about potential shorting targets, and as a catalyst for launching SEC investigations into companies Elgindy was already shorting.
According to the IG report:

During the course of the BBAN investigation, Royer began to contact Gordimer to “try to get the Commission to investigate” various other companies and individuals based on information that Royer provided to Gordimer. Royer would tell Gordimer that “he had some information about [alleged securities laws violations by public companies] that he wanted to pass along” and would ask “who at the SEC might have an open investigation about the company.” (OIG-512 report p.4)

In response to Royer’s requests, Gordimer acknowledged that he would perform a search in the NRSI database, which he described as “an internal SEC database that shows all the open investigations and closed investigations and filings of different entities,” to determine if the SEC currently had an open investigation for the company or individual. (OIG-512 report p.5)

In addition to providing this information, according to Gordimer if there was an existing investigation of the company or individual about which Royer had inquired, Gordimer would refer Royer to the SEC staff attorney conducting the investigation. If the SEC did not currently have an open investigation of the company or individual about which Royer inquired, Gordimer would take the information from Royer and look into it himself. (OIG-512 report p.5)

Gordimer testified that he knew Royer lacked the proper authorization to request such confidential information, but that he freely provided it anyway.

In September 2000, Royer’s involvement in the FBI’s White Collar Fraud unit ceased as he was transferred to Gallup, NM, tasked with investigating crimes on an area Indian reservation. And yet, Royer’s calls to the SEC continued, and in January 2001, Royer also began calling Robert Long, probing for information on confidential investigations and lobbying to get others started.

During this period, Gordimer and Long also began to deal directly with Elgindy, and both became frequent readers of his website, insidetruth.com.

Later in 2001, Gordimer acknowledged that he became aware of a correlation between the stocks that Royer asked him to investigate and the stocks that Elgindy discussed on insidetruth.com. Despite knowing about this correlation and Elgindy’s background, Gordimer insisted that Royer “wasn’t just fishing” for information by continuing to bring information to him, particularly as some of this information had resulted in the opening of a few “legitimate investigations.” (OIG-512 report p.7)

Royer informed Gordimer in January 2002 that “he was leaving the Bureau to go work for some investigative agency which…was associated [with] Elgindy. Gordimer later learned that Royer had received a job offer from Elgindy directly and that Royer would be working with…the company running Elgindy’s insidetruth.com. (OIG-512 report p.7)

Meanwhile, Royer’s requests for information about investigations into public companies slowed but did not stop, though Gordimer felt it prudent to no longer tell Royer exactly who was handling any active investigations, opting instead to provide the relevant SEC staffer with Royer’s number and instructions to get in touch with him. Either way, the outcome is the same: disclosure of confidential, highly material information to a business partner of known short seller Elgindy, despite past evidence of a correlation between such disclosures and shorting activity by Elgindy.

But wait, there’s more.

Despite the fact that Royer left the FBI altogether, Gordimer contacted Royer about an alleged false press release issued in March 2002. Gordimer said he needed information about the company “quickly” in order to determine whether the SEC should suspend trading of its stock.

The IG’s report summarizes the situation nicely as follows:

Therefore, by disclosing information to Royer about whether certain companies and individuals were under investigation, Gordimer released non-public information to Royer. Royer would then provide this information to Elgindy and his associates, and they would sell short the companies’ stock in order to earn illegal profits…By discussing non-public information with Royer without appropriate agency authorization on numerous occasions, the OIG finds that Gordimer repeatedly violated SEC policy. (OIG-512 report p.9)

Normally, such an overt pronouncement of culpability would equate to an explicit demand for one’s resignation, if not one’s termination. But lacking such authority, Kotz was forced to pass the baton to just about every one of Gordimer’s and Long’s superiors.

In light of the foregoing, these matters are being referred to the Director of Enforcement…the Associate Executive Director for Human Resources, the Associate General Counsel for Litigation and Administrative Practice, and the Ethics Counsel for consideration of disciplinary action against Gordimer and Long. (OIG-512 report p.13)

The outcome?

According to Kotz, “[Gordimer and Long] were issued written counseling memoranda and were required to attend training.” (OIG Semi-annual report, April 2010 p.67)

In other words, neither was held responsible for their deeply irresponsible behavior. And, in such a setting, the principle of moral hazard dictates that behavior will become increasingly irresponsible.

And it’s about to get much worse.

The only reason we know what little we do about the SEC’s culture of irresponsibility is the Freedom of Information Act (FOIA), which imposes much transparency on government by empowering citizens seeking access to official records. It was through FOIA that we were finally able to grasp of the true depth of the illegal naked shorting problem. FOIA also helped to identify the motives behind the illegal firing of SEC investigator Gary Aguirre and the extent of the Commission’s failures in stopping the Madoff and Stanford Ponzi schemes. And not least, FOIA made it possible for Dave Patch to acquire the above-cited internal report detailing the SEC’s role in supporting Anthony Elgindy’s illegal trading racket.

In each of these cases, the SEC was held responsible for its screw-ups only after documentary evidence was revealed – and that was only possible through FOIA requests submitted by the public and news organizations.

Today, Fox Business reports that the SEC is claiming Section 929I of the recently-signed financial reform bill exempts it from complying with FOIA. In other words, the SEC currently finds itself in a regulator’s wonderland: all of the authority and none of the accountability. If ever there was a reason to urgently contact your representative in Congress, this is it. That body must be made aware of the disaster of unintended consequences buried in the legislation they just passed. Please contact yours immediately (you can find their contact information here).

Postscript: to learn more about the Elgindy/Royer case, check out his excellent report from the series American Greed.

Eight years ago, Michael Milken, the famous financial criminal, appeared in the offices of a top Allied Capital executive. “You know,” Milken told the executive, “I already am quite a large shareholder of your stock – but my name will never show up on any list you’ll see.”

This might have been a reference to a practice called “parking stock” (owning stock but “parking” it in the accounts of friends with whom one has made under-the-table arrangements), a practice that figured in the high-count indictment that sent Milken to prison in the 1980s. It appeared to the Allied executive that Milken was fishing for inside information about Allied and threatening an attack. For a variety of reasons, short-side stock manipulators in the Milken network often accumulate large numbers of shares in the companies that they seek to destroy.

Not long after Milken’s strange appearance, David Einhorn was at a hedge fund luncheon, sitting next to Carl Icahn, one of Milken’s closest cronies. Einhorn launched his career working for Gary Siegler, who was formerly a top partner in Icahn’s investment fund, and is certainly part of the Milken network. So, it was not surprising to Allied’s executives when, halfway through the luncheon, Einhorn declared that “Allied Capital is going to zero!”

For the next eight years, Einhorn led a vicious campaign against Allied, loudly and publicly pronouncing that the company was a massive Ponzi scheme and an all-around fraud that could be as big as Enron. Of course, Einhorn’s vituperative remarks had nothing to do with the massive profits that Einhorn stood to earn from short selling Allied’s stock. Rather, Einhorn was just doing his duty as a concerned citizen – or so his slick public relations operation would have us believe.

I will give Einhorn credit. He is a master of spin. In 2008, he published an aptly titled book, “Fooling Some of the People All of the Time”, wherein he provided an ingeniously self-serving portrait of himself as a tenacious hero doing battle against not only the evil Allied Capital, but also powerful Washington insiders, financial journalists, and government regulators – i.e. all the people who reviewed his “evidence” and concluded that Allied was by no means a massive fraud.

Really, Einhorn’s book should be placed in a glass case at the Museum of Contemporary Propaganda, as it is such a work of art. Anyone familiar with the world of abusive short selling will read this book and see that Einhorn engaged in all manner of shenanigans to obtain inside information and drive down Allied’s stock price. But the dark genius of Einhorn’s book is that it manages to portray his malefaction as par for the course – just another day in the life of a noble fraud-buster.

For example, Einhorn admits in his book that he invested in a fund run by a man who had recently served as the chairman of Allied Capital’s board of directors. Could this investment have been a bribe? Was Einhorn seeking inside information about Allied? Certainly not. The investment was purely incidental, Einhorn assures us. And you, dear reader, should be ashamed of yourself for even asking such questions. Indeed, your suspicions make you part of the problem. You are an ignorant thug who wants to “intimidate” Einhorn and other short selling “critics” who selflessly do battle with public corporations.

In his book, Einhorn notes the SEC initiated an investigation into his short selling of Allied Capital. In the course of this rather cursory investigation, an SEC official sought to determine whether Einhorn was colluding with other hedge funds, including William Ackman’s Gotham Partners (now called Pershing Square Capital) and Whitney Tilson’s T2 Partners, to drive down Allied’s stock. The official asked this question:  “Mr. Einhorn, have you ever compensated [short selling hedge fund] Gotham Partners…for providing you with an investment idea?”

Einhorn answered, “Except in-kind, no.” Then Einhorn consulted with his lawyer and changed his mind. He went back to the SEC official and said, “I think the more correct answer to your question is that there’s been no compensation for the ideas.” The moral of this story, according to Einhorn’s book, is that the investigator was a bumbling idiot for asking such a question. And, you, dear reader – don’t even think of asking the same question. If you do, you’re part of the problem. You’re trying to “intimidate” Einhorn.

You see, it is perfectly natural for hedge funds to share ideas. Of course, hedge funds must not be required to report their short positions to the SEC or otherwise disclose their “proprietary trading strategies.” Hedge fund trading is top-secret so far as the public is concerned. But, says Einhorn, when we hedge funds “share ideas,” it’s just us pros talking shop. Really, says Einhorn, you can trust me…and, oh, did I say “payment in-kind”? Oops — slip of the mind.

Is it possible that hedge funds exchange “ideas” because it is profitable for them to do so? Surely not. Is it possible that these “idea” exchanges are nothing more than collusion – hedge funds agreeing to pile on to the same companies to put downward pressure on stock prices? How dare you ask such a question. Allied Capital asked that question. And Allied is very bad, says Einhorn — Allied tried to “intimidate” me!

Really, Einhorn says this all the time – people tried to “intimidate” him. He was hurt. But he’s a hero. He stood up to the critics. And, he assures us in his book, it was perfectly natural for him to collude (sorry, “share ideas”) with not just Tilson and Ackman, but also Eastbourne Capital’s Jim Carruthers. You see, Carruthers is really smart guy who does good research.

What Einhorn does not mention in his book is that Carruthers has sometimes spelled his name with a ‘K’ to disguise his identity while passing himself off as a friendly private investigator in order to deceptively acquire inside information from companies like Allied Capital. But let’s not criticize Carruthers. We don’t want to “intimidate” him. We don’t want to be part of the problem.

And shame on the SEC for having the temerity to investigate Einhorn. In fact, the SEC did nothing but ask Einhorn a few questions. Meanwhile, Einhorn convinced the SEC to launch an investigation of Allied. Then Einhorn all but directed this massive but ultimately misguided investigation for a period of three long years.

As Einhorn admits in his book, his hedge fund partner had a “social” relationship with William Donaldson, then the Chairman of the SEC. That’s how Einhorn got the investigation of Allied started. As the investigation progressed, Einhorn says, SEC officials even asked him to be their “cartographer” – outlining all the ways in which Allied was supposedly a massive Ponzi scheme, and also failing to mark its assets to “fair value” (i.e. the arbitrary value at which Einhorn believed the assets could be sold in a fire sale).

Clearly, Wall Street miscreants like Einhorn had captured the SEC to the point where the Wall Street miscreants were virtually running the place. But in the upside down reality presented by Einhorn’s book, the fact that a few SEC officials doubted the hedge fund manager’s sincerity is proof that the commission had been corrupted, not by Wall Street miscreants, but by corporate executives who wanted to “intimidate” Einhorn.

That’s right, the SEC, following Einhorn’s orders in microscopic detail, conducted an investigation of Allied that was so huge that Allied had to create a “Department of Investigations” to handle all of the commission’s requests for new information. But it was Allied’s executives, not Einhorn, who were peddling influence at the SEC. You don’t believe it? Read Einhorn’s book – agitprop at its best.

As for the media – well, Einhorn is deeply disappointed. Of course, Einhorn heaps praise on journalists such as Jesse Eisenger, then of The Wall Street Journal; Carol Remond of Dow Jones Newswires; and Herb Greenberg, formerly of MarketWatch.com and TheStreet.com. These journalists wrote multiple negative and false stories about Allied Capital, precisely mimicking Einhorn’s allegations that the company was a massive fraud.

As it happens, these are the same journalists that Deep Capture has shown to have had too-cozy, and in some instances, outright corrupt relationships with a select crew of short selling hedge fund managers, including David Einhorn. Indeed, it is fair to say that Einhorn and others in his network had captured some of the biggest names in financial journalism to the point where the hedge fund managers were able to virtually dictate the journalists’ stories.

But Einhorn was disappointed – the media failed him. That is to say, a number of honest journalists looked at Einhorn’s “evidence” and concluded that it was balderdash of the highest order. But, no, these journalists were not honest. They were ignoramuses. They are part of the problem. They should be publicly shamed. One of them even investigated Einhorn. This was an outrage. It was hurtful. It was “intimidation.”

Look, lying and cheating short-sellers are essential watchdogs, they add liquidity to the markets, and they are really very fragile people. Nice people, too. They don’t even care about money. You don’t believe me? Read Einhorn’s book. “I remember Grandpa Ben…,” Einhorn writes on page one, and after that he regales with countless folksy anecdotes and assorted other bullshit that – well, believe me, it brings tears to the eyes.

Einhorn even lets us know that he is going to donate some of the proceeds from his short selling of Allied to needy children. “I have been waiting,” he writes, “but the children should not have to wait.”

As far as I know, the children are still waiting. Although Einhorn has made enormous profits from his short selling of Allied, he has provided no evidence that his contributions to charity have significantly increased. But it is clear that the purpose of his book was not to tell the truth. It was to inoculate himself from public criticism and regulatory scrutiny in preparation for his next big project – the destruction of Lehman Brothers.

In May 2008, soon after releasing his book on Allied Capital, Einhorn’s launched his attack on Lehman in a speech that he gave at an event that was ostensibly held for the purposes of – what else? – raising money for needy children. Einhorn began this speech by discussing his supposedly philanthropic fight with Allied. He then  proceeded to give a grossly exaggerated account of Lehman’s problems, suggesting that Lehman was a massive fraud for precisely the same reasons that Allied was a massive fraud – namely, that it had failed to mark down its real estate assets to “fair value,” with “fair value” defined not by any reasonable metric, but by Einhorn himself.

Lest there still be any doubt that Einhorn really was a crusading crime-fighter, rather than a profit-seeking hedge fund manager, he hired an expensive lobbying outfit called the Gordon Group to orchestrate an astounding public relations campaign. The Gordon Group, whose key clients seem to be Einhorn and Einhorn’s network of hedge fund managers (including the above mentioned William Ackman and Whitney Tilson) is staffed by real professionals. Their Einhorn campaign was marked by the sort of hype that normally accompanies the launch of a new teen-idol band.

But it wasn’t just hype. It was also a particularly greasy sort of deception – imagine a pimp marketing a cheap 42nd Street hooker. Really, she’s not in it for the money. She’ a virginal college undergrad who loves her teddy bear.

Well, the media swooned for the cuddly Einhorn. This was the same media that Einhorn had accused of bungling idiocy, but never mind that – now he had glowing profiles in many of the top news publications, and a three-hour appearance on CNBC.  Half-way through his CNBC debut, Einhorn put on a cute t-shirt painted by his young kids — just to show that he was a regular guy and a lover of children, as opposed to a marauding hedge fund manager seeking to obliterate one of America’s largest investment banks.

In all his media interviews, Einhorn reminded journalists that Allied Capital had “intimidated” him. He said he had stood up to the bullies and proven that Allied was a massive fraud. Then he smoothly transitioned into a discussion of Lehman Brothers, suggesting to the journalists that Lehman was just like Allied, a massive fraud. He said Lehman was trying to “intimidate” him, but he would fight on in the name of truth and justice. The journalists swallowed this nonsense without an ounce of skepticism.

I do not mean to suggest that Lehman Brothers was a clean bank. Clearly, it engaged in some shady accounting, including its now notorious Repo 105 transactions. Its brokerage probably catered to criminal market manipulators. But while Lehman was a deeply troubled bank, it is also true that it was subjected to a wave of false rumors, each one accompanied by illegal naked short selling. With all the manipulation that accompanied the attack on Lehman, it was difficult to know what the truth about the company really was.

In the midst of the attack on Lehman, Adam Starr, the manager of hedge fund Gulfside Partners, was moved to write a letter to Lehman’s CFO, stating, “I have never witnessed more disruptive behavior than that displayed over the past year by David Einhorn.” In a recent interview with Reuters, Starr said that Lehman had clearly had serious problems, but that was besides the point. The point, Starr said, was that Einhorn was up to no good – “manipulating the market and running a high publicity business is just not appropriate behavior and disruptive to free and open markets.”

As for Einhorn being “right” about Lehman, it is important to note that the court-appointed examiner’s report on the Lehman bankruptcy does not support Einhorn’s principal claim – that Lehman’s executives fraudulently and massively overvalued the bank’s commercial real estate assets. “With respect to commercial real estate,” says the report, “the Examiner finds insufficient evidence to conclude that Lehman’s valuations of its Commercial portfolio were unreasonable as of the second and third quarters of 2008.”

Lehman’s valuations might have been high, but Einhorn’s shrill exaggerations and insinuations of fraud were clearly designed to induce panic. And sure enough, panic ensued. With potential business partners wondering whether Lehman was, in fact, massively overstating the value of its commercial real estate, the bank was unable to raise new capital.

To protect itself, Lehman sought to spin off the real estate assets, but by that time it had come under a brutal and criminal naked short selling attack, with more than 30 million of its shares failing to deliver. The plummeting stock price and continuing false rumors in the marketplace derailed Lehman’s other efforts to protect itself and triggered a run on the bank that ended with Lehman’s demise.

In short, Lehman was a bad bank. Regulators should have forced it to reform. Instead, they and the media allowed short selling “vigilantes” like Einhorn to manufacture a much bleaker reality and bring a major investment bank to its knees. It is quite possible that if it weren’t for Einhorn and other dissembling investor “activists”, Lehman would have survived, and the financial system would have had a much softer landing.

Lehman has subpoenaed records from Einhorn and his close colleague, Steve Cohen of SAC Capital,  in hopes of determining the extent to which the hedge fund managers had a hand in its demise. Perhaps those subpoenas will give us a clearer picture of what really went down, but meanwhile we can expect Einhorn’s PR machine stay “on message” – constantly repeating that Einhorn was “right” about Lehman, just as Einhorn was “right” about Allied Capital.

Which brings us to the inspector general’s report on the SEC’s investigation of Allied. Given that Einhorn, his minion Jim Brickman, and the rest of his PR machine are waving this report with glee, and no doubt preparing to use it as cover for Einhorn’s next attack on a public company, it is important that we subject the contents of the report to close scrutiny.

The report concludes that “serious and credible allegations against Allied were not initially [my emphasis] investigated” by the SEC, but contrary to Einhorn’s ridiculous claims that nobody listened to him, the inspector general notes that the SEC did ultimately conduct “a lengthy examination of Allied as a result of Einhorn’s allegations…”

SEC officials met with Einhorn on multiple occasions to review his allegations. They also scoured through millions of Allied emails and the cart-loads of other documents that Allied supplied every time Einhorn came to the SEC with a new set of accusations.

Having conducted this gargantuan investigation, the SEC concluded that most of Einhorn’s allegations were bogus. Allied was fined for having mildly inadequate accounting methods that might have overvalued some of the company’s assets, but the SEC determined that Allied certainly was not the “massive fraud” that Einhorn claimed it to be.

In addition, Allied was not, as Einhorn claimed, a massive Ponzi scheme. Einhorn had made the smarmy suggestion that Allied was a Ponzi because it supposedly raised money from the markets to pay its dividends. An SEC official told the inspector general that this claim was patently false – it was perfectly obvious that Allied legitimately paid dividends out of earnings.

The inspector general’s report notes that one SEC official claimed to have gotten “push back” when she tried to dig deeper into the Ponzi scheme allegation. But nowhere in the report does the inspector general conclude that any such Ponzi scheme existed. Clearly, Einhorn is no Harry Markopolos. Markopolos uncovered a $50 billion fraud (that of Bernie Madoff). Einhorn blew the whistle on a crime that didn’t exist. Yet, Einhorn’s slithering PR effort never ceases to amaze – somehow he has managed to attach himself to Markopolos, and even wangled a deal to write the introduction to Markopolos’s blockbuster book.

The inspector general seems to believe that the investigation of Allied could have been more thorough in some respects. For example, SEC officials didn’t visit Allied’s offices, and one SEC official was a bit too quick to believe that Allied was innocent just because former SEC officials worked for the company. But, again, the inspector general does not state that the SEC was wrong to conclude that Allied was innocent of any major crime.

The inspector general’s most damaging conclusions about Allied concern the company’s efforts to lobby the SEC. Apparently, some Allied lobbyists secured an unusual meeting with SEC officials and managed to convince these officials that Allied deserved a lighter fine. It also appears that a former SEC official went to work as an Allied lobbyist and might have gotten his hands on Einhorn’s phone records.

The inspector general is right to suggest that Allied’s lobbyists crossed the line. It is not kosher for a public company to pry into a private citizen’s phone records. But given that Einhorn had all-but moved his offices into SEC headquarters, and given that Einhorn had his own private investigators going to unknown lengths to dig up “dirt” on Allied (he admits in his book that he hired Kroll, a private investigative agency that owes its existence to Michael Milken, who was its first big client), Allied can hardly be blamed for taking steps to defend itself.

In any case, the inspector general’s report is more an indictment of the SEC than of Allied’s lobbyists. The overall picture that emerges is one of a government agency split into two factions, one populated by friends of Allied’s lobbyists, the other populated by officials who were basically taking orders from hedge fund managers like David Einhorn. It seems that nobody at the SEC was capable of conducting an investigation without having his or her hand held by some self-interested party. But it is clear from this case and many others like it that the hedge fund faction won the day.

The inspector general states in his report that it was Allied’s lobbyists who convinced the SEC to investigate Einhorn. The report concludes that the SEC initiated this investigation “without any specific evidence of wrongdoing.” That might be so, but officials do not generally obtain “specific evidence” unless they seriously look for it. And it is clear from the contents of the inspector general’s report that the SEC’s investigation of Einhorn was an unmitigated joke, even though officials had good reason to suspect that Allied’s stock was being manipulated.

The report notes, for example, that the SEC subpoenaed Einhorn’s client list in response to Allied’s complaints and discovered that Einhorn had a certain “celebrity client”, whom the inspector general does not name. Could this “celebrity client” have been Michael Milken? We cannot know for certain, but it seems like a good guess, given that the discovery of this “celebrity client” followed Allied’s complaint to the SEC, and given that Allied had complained that Einhorn might be colluding (sorry, “sharing ideas”) with one specific celebrity – Michael Milken.

In any case, it appears from the inspector general’s report that the SEC did nothing to determine how Milken, who is banned from the securities industry, became “quite a large” shareholder of Allied’s stock. Nor did the SEC seek to determine what Milken was doing that day in Allied’s offices.

Meanwhile, some SEC officials seemed to believe that Einhorn was colluding with other hedge fund managers to drive down Allied’s stock. To see whether the hedge fund managers called each other and then placed their trades at precisely the same time, the SEC subpoenaed Einhorn’s phone records. But according to the inspector general’s report, Einhorn did not bother to comply with this subpoena. He never handed over the phone records, and nobody at the SEC seemed to notice or care. Which is funny, because Einhorn states in his book that he did hand over his phone records. Indeed, he goes to great lengths to describe how hurt he felt about this. The SEC was “intimidating” him.

Perhaps because it was weary of “intimidating” hedge fund managers, the SEC also apparently did nothing to investigate illegal naked short selling of Allied’s stock. From the moment that Einhorn declared that Allied was “going to zero”, and for many months afterwards, Allied’s stock “failed to deliver” in massive quantities – a sure sign of criminal naked short selling. We do not know that Einhorn, others in the Milken network, or their brokers were committing this crime. Maybe it was someone else. Either way, it was not beyond the pale for Allied to ask the SEC to investigate. Or maybe it was. After all, the SEC wouldn’t want to “intimidate” criminals.

It is also notable that literally minutes after Einhorn declared that Allied was “going to zero”, the corrupt law firm Milberg Weiss filed a class action lawsuit against Allied that almost precisely mimicked Einhorn’s allegations. Indeed, Milberg filed a class action lawsuit against nearly every company attacked by short sellers in the Milken network.

A couple of years ago, Milberg’s top partners went to jail after prosecutors determined that the partners routinely bribed the plaintiffs in such lawsuits and knew in advance that some event would collapse the stock prices of the companies named in the lawsuits. Einhorn claims that the timing and contents of Milberg’s lawsuit were coincidences. We’ll never know the truth because the SEC doesn’t want to “intimidate” short sellers and corrupt law firms.

There were other “coincidences”. For example, supposedly “independent” financial research shops, such as Off Wall Street Research and Farmhouse Equity Research, published reports that closely paralleled Einhorn’s negative analysis of Allied Capital. The Motley Fool reported in 2007 that Einhorn’s confederate Jim Brickman helped Farmhouse write its research on Allied, and received a copy of at least one of these research reports one week prior to its publication.

Brickman, who is a bit of a mystery character (he refused to provide me with any information about his background), told the Motley Fool that he and Einhorn didn’t see the advance copies of the reports because of “travel constraints.” Allied complained to the SEC that the research shops were helping Einhorn manipulate its stock price and illegally trade ahead of their research. Einhorn said Allied was trying to “intimidate” the research shops. Who was right? It was all so confusing. The deep thinkers at the SEC picked their noses and tried to figure it all out. Then they went to lunch.

The inspector general has been on a mission to expose ineptitude at the SEC, and for this he deserves praise and gratitude. However, given the facts, I think his report on the investigation of Allied Capital was a bit too kind to David Einhorn. The inspector general notes that his office “conducted a comprehensive investigation of the allegations in Einhorn’s book.” But the report offers no solid verdict as to the accuracy of those allegations, and fails to acknowledge the extent to which the SEC had been manipulated by Einhorn and affiliated Wall Street hedge funds.

It should be noted that not only the SEC, but also the Department of Justice, the Small Business Administration, federal courts, attorneys general, and other government bodies investigated Einhorn’s allegations against Allied. All of these investigations yielded the same conclusion: Einhorn’s allegations were, for the most part, eminently ridiculous.

The only criminal fraud discovered by any of these investigators was committed by executives of Business Loan Express, a subsidiary that represented a tiny fraction of Allied’s overall portfolio. The BLX executives were apparently handing out Allied’s money to unqualified borrowers who were their cronies. In other words, Allied was the victim of this fraud. That anyone at the SEC still gives credence to David Einhorn is, therefore, rather odd.

But this story has a happy ending. Last October, Allied Capital was purchased by Ares Capital Corporation, a company that was founded by Anthony Ressler and John Kissick – both partners in the private equity firm Apollo Management. The head of Apollo is none other than Leon Black, who is Michael Milken’s closest business crony. That could be a coincidence. Or it could be that Einhorn’s attack on Allied was meant from the beginning to drive down Allied’s stock price to the point where it would be ripe for a takeover by Milken’s pals.

In any case, Einhorn mysteriously ended his “crusade” agains Allied as soon as Allied was purchased by his friends. So, for the time being at least, we don’t have to listen to his blather. And we promise – never again will we “intimidate” Einhorn. Really, no more “intimidation” — not from us. Mr. Einhorn, you are noble man. You did it for the children. You did not deserve to be “intimidated.” And, Mr. Einhorn, one more thing — boo!

Oops, did it again.

* * * * * * * *

Click here to read the inspector general’s report

Though evidence has mounted for a while, today it became official: Goldman Sachs (NYSE:GS) is now on its own, as the guardian angel/demon that once enabled the firm’s assault on our capital markets has clearly severed that relationship. At least that’s the conclusion I draw from the news that Goldman was censured and fined by NYSE and the SEC for specific faults in “execution and clearing” (another way of saying “naked short selling”).

What changed? After all, Goldman is still rich, right?

Well…sort of. Goldman may be flush with cash, but with pressure mounting on politicians to reject any of it in the form of campaign contributions, suddenly that cash doesn’t spend nearly as well as it used to.  At the same time, it’s probably safe to assume Goldman’s allure as a future client has been severely degraded in the eyes of private sector career-minded regulators.

In other words, Goldman’s gold has lost its luster, and with it, the firm’s political ‘juice’. I can only imagine the look on their faces when Goldman brass first realized why their calls were not being returned: their power was gone. And folks with badges were knocking on the door.

Goldman’s role as a facilitator of illegal, short-side market manipulation will never come to symbolize its villainy in the mind of the public the way knowingly selling its clients garbage CDOs on behalf of John Paulson will. But that’s what makes this latest development even more significant: it suggests a sort of “piling on” mentality that was inconceivable just one month ago (keep in mind this is the company that, evidence suggests, successfully lobbied to have even legitimate short selling banned once the practice began to impact its share price). This, in turn, may be an inadvertent signal from regulatory “insiders” that Goldman’s prospects of emerging intact from this storm are slim.

Do not mistake the tone of this post for contentment, for this particular action doesn’t come close to addressing what I suspect is the true breadth and depth of Goldman’s role in short-side market manipulations. Indeed, the bulk of this particular complaint focuses on a few infractions observed over a few weeks in late 2008. Goldman, for its part, attributes the problem to an inconsequential bookkeeping error. If that’s true, a half-million dollar fine for an accounting mistake makes Goldman’s plight seem even more dire.

In the end, what’s most significant about this complaint is the insight it provides into how the system works when inappropriate influence ceases to be a factor in the regulatory process (something we’ve grown accustomed to not seeing): investigators investigate, infractions are cited, penalties applied, juice ignored.

I’m not convinced it’s within human nature to develop a financial markets regulatory paradigm able to consistently achieve this ideal (though I’m certain we can do better than what we’ve got). The alternative is to focus on the other side of the equation by limiting the capacity of any market participant to become so influential the rules cease to apply.

Just to make sure everybody agrees that $7-billion is a lot of money – keep in mind it exceeds the GNP of 40% of the nations on earth. Imagine putting a match to all the goods and services produced in one year by the people of Laos or Mongolia. Stanford is accused of doing that, and more. But because it’s just a tenth of the wealth destroyed by Madoff, Stanford may forever be regarded a Ponzi also-ran.

But dig a little deeper and you’ll find the Stanford case is the bigger outrage by far, not so much for the scam itself, but for the shocking behavior of the regulators tasked with preventing it. Where Madoff was enabled by SEC bureaucratic incompetence, Stanford was empowered by overt SEC indifference.

That’s right – indifference. Unlike Meghan Cheung, the former head of enforcement at the SEC’s New York branch, who didn’t know how to determine whether Madoff was running a Ponzi scheme, her counterpart in Fort Worth spent years swimming in evidence of Stanford’s scam, but simply preferred not to do anything about it.

The evidence, if you can stomach it, is oozing out of the report recently submitted by SEC Inspector General extraordinaire David Kotz. In it, we learn that SEC examiners spotted the red flags as early as 1997, and spent eight years lobbying then-chief of Fort Worth’s enforcement division, Spencer Barasch, to investigate. Barasch repeatedly declined, even as evidence of the Stanford scam – together with the size of the scam itself – grew exponentially.

The first referral by SEC examiners was sent to Barasch in 1998. According to the testimony of Julie Preuitt, who helped author the request, Barasch declined to investigate after discussing the matter with Stanford’s legal counsel at the time, former SEC Fort Worth District Administrator Wayne Secore.

According to the report:

Barasch told Preuitt “he asked Wayne Secore if there was a case there and Wayne Secore said that there wasn’t. So he was satisfied with that and decided not to pursue it further.”

Obviously, Barasch denies this, and such a claim would be difficult to believe were it not for the well-documented facts that follow.

Barasch finally left the SEC for a spot as partner in the law firm of Andrews Kurth in 2005, shortly after putting the kibosh on a third attempt by SEC examiners to investigate Stanford. Barasch’s replacement accepted a similar recommendation later that year, but the resulting inquiry was mismanaged and did not produce an enforcement case until February 2009, after the Commission’s hand was forced by Madoff’s admission two months earlier.

But it was what happened after Barasch’s departure from the SEC that casts his earlier actions in a much harsher light. As the investigation discovered:

[Barasch], who played a significant role in multiple decisions over the years to quash investigations of Stanford, sought to represent Stanford on three separate occasions after he left the Commission, and in fact represented Stanford briefly in 2006 before he was informed by the SEC Ethics Office that it was improper to do so.

The final of Barasch’s three attempts to represent Stanford was by far the most brazen, not to mention instructive. It happened in February 2009, immediately after the SEC filed suit against Stanford. Like the two before it, the third was also denied. When asked to justify the renewed request, Barasch replied,

“Every lawyer in Texas and beyond is going to get rich over this case. Okay? And I hated being on the sidelines.”

In email, veritas.

Not only was Barasch apparently numb to the definition of “ethical conflict,” he seems to have used it as a business development tool, at least that’s the impression left by an email not included in the Kotz report but acquired by the Dallas Morning News. According to the email, after Mark Cuban was sued by the SEC’s Fort Worth office for insider trading in 2008, Barasch told an associate of Cuban’s,

“I am friends with and helped promote two of the guys who signed the Complaint against Mark. Someone should tell Mark to look at my profile on my firm website, my SEC press releases, and advise Mark to add me to his defense team.”

It’s safe to say that Barasch plays the heavy in the IG’s report, but read it carefully, and you’ll find that he’s not the real villain. Instead, that role is played subtly but consistently by the broader SEC Enforcement Division’s flawed culture.

As the report stated,

We found that the Fort Worth Enforcement program’s decisions not to undertake a full and thorough investigation of Stanford were due, at least in part, to Enforcement’s perception that the Stanford case was difficult, novel and not the type favored by the Commission. The former head of the Fort Worth office told the OIG that regional offices were “heavily judged” by the number of cases they brought and that it was very important for the Fort Worth office to bring a high number of cases…The former head of the Examination program in Fort Worth testified that Enforcement leadership in Fort Worth “was pretty upfront” with the Enforcement staff about the pressure to produce numbers and communicated to the Enforcement staff, “I want numbers. I want these things done quick.” He also testified that this pressure for numbers incentivized the Enforcement staff to focus on “easier cases” – “quick hits.”

And these instructions were predictably manifest in the handling of the Stanford case, as evidenced by the reaction to an anonymous Stanford insider’s letter, first sent to the NASD, denouncing Stanford as a Ponzi scheme. The letter was forwarded to the SEC where Barasch saw and ignored it, saying,

“Rather than spend a lot of resources on something that could end up being something that we could not bring, the decision was made to not go forward at that time, or at least to not spend the significant resources and wait and see if something else would come up.”

The report also cites a former Fort Worth office administrator who says Barasch and others in his group had been subjected to criticism from high-level SEC staff in Washington DC for “bringing too many Temporary Restraining Order, Ponzi, and prime bank cases.”

Accordingly, Fort Worth was admonished to avoid investigating “mainstream” cases in favor of simple accounting fraud.

Now, let’s take a step back to see what insights into the SEC’s enforcement paradigm might be gleaned from what we’ve learned so far.

1. Given his actions both prior to and after leaving the Commission, I suspect Spencer Barasch’s approach to regulating Stanford – and presumably other entities – was heavily influenced by a desire to maximize his eventual private sector opportunities. This is further evidence that the significance of regulatory capture and the revolving door ethic in the minds of SEC enforcement officials cannot be overstated.
2. Whereas “Ponzi and prime bank cases” most often apply to investing institutions, while accounting fraud charges are most often leveled against public companies, I suspect the high-level mandate to prefer the latter over the former to be the root of the SEC’s long-suspected anti-issuer/pro-institutional investor bias – or at the very least, further evidence of it.
3. This apparent anti-issuer bias, paired with the report’s well-documented evidence of the SEC’s preference of case quantity over quality, offers additional support for the widely-held belief that cases against public companies are seen as low-hanging (and career-protecting) fruit in the eyes of Enforcement Division staffers.

If my conclusions are correct, then the Stanford outrage is not really about Spencer Barasch, but the SEC’s flawed enforcement culture, from Washington DC on down. I further suspect this culture to be a key factor in explaining the SEC’s role as enabler of the stock manipulation schemes extensively documented here on Deep Capture.

But don’t take my word for it. Instead, consider the words of then-Director of the SEC’s Division of Enforcement, Linda Chatman Thomsen, responding to a question posed by a member of the audience following her keynote address at the US Chamber of Commerce’s 2008 Capital Markets Summit.

Audience member: “You spent a lot of time talking about insider trading and penny stock fraud, but you failed to mention an issue that’s of great concern to the Chamber, and that is naked short selling and the unsettled trades that can result from that. How can the Commission claim that it is serious about enforcement when millions of trades fail to settle every day and companies remain on Reg SHO Threshold Lists for years and years?”

Thomsen: “As to naked short selling, and more generally market manipulation generally, it is an area we are focused on. We have seen fewer cases in that arena because, often times, this is not necessarily with respect to naked shorts, but shorting or market manipulation more generally, because often the components of something that might look to be manipulative are all legal trades as you point out. So it’s a hard case to bring, which is not to say that it isn’t something that we don’t investigate, because we do. So I hear and understand the frustration of many on the subject of short selling generally. When we hear complaints about short selling—and, frankly, it is both short and naked short, it is a combination of both—we routinely hear from companies who’ve come in, who worry that they’re being shorted in an illegal way. We routinely take all that information in and look into it.

“And often times, as I think many defense counsel would be happy to tell you, when we dig in, what we find is that some of the information that has caused people to be shorting is actually true as to the company, and we may very well be confronted with two issues, one on the company and its disclosure side as well as on the trading side. But they’re very difficult cases, which is not to say that we aren’t focused on them and interested in them and indeed this new focus that we have on some smaller companies and smaller issuers will wrap some of those concerns into their focus as well.”

Thomsen’s answer needs to be examined from two angles: what she said and what she (meaning, her division) actually did.

What Thomsen said, was that when it comes to illegal, manipulative naked short selling, “it’s a hard case to bring,” and that it often it turns out the targeted company deserved to have its stock manipulated. But don’t worry…the SEC Division of Enforcement cares and regularly investigates complaints of illegal, manipulative short selling.

What Thomsen’s division actually did was quite different. We know this thanks to another outstanding report by SEC Inspector General David Kotz relating to the Commission’s handling of complaints of illegal, manipulative naked short selling between January 2007 and June 2008. What Kotz discovered was that of the more than 5,000 complaints received by the Division of Enforcement during that time, not one resulted in an investigation.

Kotz further found that while robust methods exist for dealing with complaints relating to “spam driven manipulations, unregistered online offerings and insider trading” (again, infractions typically committed by issuers), no written policies existed for dealing with complaints of illegal naked short selling. This “[has] the effect of naked short selling complaints being treated differently than other types of complaints.”

And in this case, “differently” meant “not at all.” This attitude closely mirrors that of the SEC’s Division of Enforcement as described in the Stanford report.

In my opinion, the best thing to happen to the SEC in many years is the arrival of Inspector General David Kotz. The second best thing is the February 2009 departure of Linda Thomsen. In the months following the arrival of Thomsen’s successor, Robert Khuzami, many encouraging developments have been observed, including two enforcement cases brought against manipulative naked short sellers, the permanent adoption of regulations greatly reducing instances of such manipulation, and the recent case brought against Goldman Sachs (NYSE:GS). Each of these represents an important departure from the SEC’s long-standing anti-issuer/pro-bank approach to regulation.

These positive developments notwithstanding, the dysfunctional culture at the SEC’s Division of Enforcement was undoubtedly a long time in the making. As a result, it will require a long time to root out. Unfortunately, we don’t have a long time. Investor confidence in the fundamental fairness of our capital markets must be restored now, not as long as it takes the old guard’s institutional memory to fade away. Having read the Stanford report, the only practical solution I see is a new beginning. Congress needs to sunset the SEC on an immovable — and ideally not too distant — date certain and instruct the Department of Justice to have a replacement ready to begin work the next day.

The next best solution would be to disband the SEC entirely, and send big, red warning letters to all potential market participants, giving them fair warning that they’re on their own.

These may seem like desperate measures, but I suspect you’ll agree these are becoming increasingly desperate times.

“America’s capital markets are too large and complex for our regulators to handle. As a result, overvalued, scamming companies run rampant, defrauding investors. We, the naked short sellers, are doing the rest of you a favor by taking the law into our own hands in an effort to short these companies out of existence, or at the very least depress their share prices such that when they finally do fail, the rest of you will not lose as much as you would have. So you’re welcome.”

This silly idea is taken directly from anarcho-capitalism: an economic and political philosophy describing how market participants themselves, operating in the absence of government regulation, might find a profit motive in the maintenance of order.

To be fair, these “principled” naked short sellers and I do in fact agree on one matter: the fact that our markets are operating without an effective regulator. And I’ll also concede that there was a time when the rest of this anarcho-capitalist manifesto might have applied; specifically, many years ago, when manipulative short sellers limited their activities to micro-cap companies that were expert at selling: not goods or services, but stock. And because the world of penny stocks is recognized by all as a financial Wild West to begin with, this form of frontier justice – though distasteful – was allowed to fill a niche in the great financial ecosystem…akin to the fleas biting the rats feeding on the scraps fallen from the table of American capitalism. Then, for reasons too complicated to fully explain here, following the market crash of 1987, predatory short selling began to move from the shadowy back alleys and onto Wall Street, where, within less than two decades, these parasites had moved far up the food chain, never quite able to satisfy their blood-lust, while regulators continued looking the other way.

I offer all this information as background, in order to help you more fully appreciate what follows.

Last month, the Deep Capture team began to spot patterns in the equities and options trading of companies whose stock experienced unusually high levels of sustained delivery failures: a sure sign of manipulative naked short selling. We determined that certain pairs of transactions (what we’ve come to call “matched blocks”) faithfully predicted the numbers of shares that would go on to be reported as undelivered by the seller two trading days later. Because delivery is only considered “failed” after three trading days (T+3), and these transactions were taking place on T+1, we realized that they must be happening in response to the naked shorts generated on T+0; specifically, that these trades are likely intended to give the appearance that the SEC’s mandatory close-out requirement has been met, thus “resetting” the three-day clock ticking down until delivery is forced.

This sort of thing is not supposed to be happening, by the way. It’s illegal, and, under significant political pressure, last year the SEC lightly reproached three other firms for engaging in identical activity.

Whatever the case, these matched blocks, which we can observe in near-real time, proved uncanny predictors of failed trades reported by the SEC in much-less-than-real-time (usually delayed by two to three weeks). We took advantage of this reporting time lag to publicly predict – based on the matched blocks – delivery failures in shares of Sears Holdings (NASDAQ:SHLD) several days before those figures were released.  When they finally were, our predictions proved accurate to within 2.5% — including faithfully anticipating a near 50% drop from one day to the next.

After publishing these predictions for Sears, I posted messages alerting readers of stock message boards dedicated to discussing Amedysis (NASDAQ:AMED) and Mannkind Corp. (NASDAQ:MNKD): two other companies whose trading data demonstrated links between matched blocks and delivery failures nearly identical to that of Sears, and where many posters were attempting to understand – though with only fragmentary information – what was going on.

All along, it was my intention, upon finishing my analysis of apparent manipulation in Sears, to raise awareness of the same sort of activity in Amedysis and Mannkind; however I never really had the chance, because it appears the would-be manipulator got spooked by the attention and decided to move on, covering at what was almost certainly a hefty loss.

In fact, the similarities observed in the trading of these three stocks from unrelated sectors (a brick-and-mortar retailer, a biotech firm and a provider of home health care), is somewhere between striking and spooky. In each case, the volume of the matched blocks reached their peaks on February 17 (the date of publication of my Sears prediction), and then abruptly tapered off. By March 2, Mannkind was off the Threshold list. By March 3, Sears Holdings was off the Threshold list. By March 22, Amedysis was also off the list.

It’s impossible to be certain whether the attention brought by Deep Capture had anything to do with the sudden abandonment of what had been a concerted effort at downward manipulation of the stock prices of three decidedly non-scam companies; yet the coincidences are too many to be ignored (there are others, by the way).

The idea that we might have had something to do with helping to restore fairness to the markets for these stocks, combined with my remembrances of the so-called anarcho-capitalist ideal described above, got me thinking about a new way of approaching this blog:

Because our financial markets are so large and complex, and our financial markets regulator so captured and inept, stock manipulating hedge funds have been running rampant, damaging companies and defrauding investors.  We, the investigative bloggers, are stepping in to do the job the SEC either cannot or will not do, by shining a bright light on acts of  manipulation when we see them, and publicly identifying the perpetrators (yes, we’ve figured out ways to potentially accomplish this, as well) when able. And we’ll continue doing it, until either America’s stock settlement system is repaired, or the SEC returns from its several decades-long coffee break.

That’s right. The naked short sellers offer anarcho-capitalism, and DeepCapture.com responds by giving them a dose of anarcho-regulation.

So far, at least as far as bloggers and YouTube commenters are concerned, response to the video has come in five flavors:

1. Approval
2. Nutty approval (“This makes me so angry I want to take to the streets in bloody revolution! It’s all [insert political party or current/past president]’s fault! ”).
3. Tentative approval (“You’ve got part of the story right, but the real problem is…”)
4. Random and unaware (“I’ve got a puppy named Patches. He has a wet nose.”)
5. Nutty disapproval (“[Insert anything Gary Weiss would say]”)

What’s been missing is educated criticism based on the hard facts presented in the video. And believe it or not, this has bothered me, because it suggests that not enough smart people are paying attention.

As I mentioned, that changed this week when Mike “Mish” Shedlock of SitkaPacific Capital Management analyzed the video on his blog and managed to make a compelling contrary case. Though compelling, Mike misses the mark on a few key points and his analysis requires a rebuttal, which I’ve decided to offer here as it would probably be of interest to DeepCapture.com readers.  I’ve also invited Mike to respond, and will print whatever he offers at the end of this post.

(If you’ve not seen the video yet, I encourage you to watch at least the first five minutes now, otherwise nothing that follows will make much sense.)

Shedlock frames his criticism of the video in terms of what he identifies as three assumptions (printed verbatim in black, with my response in blue italics).

1. That whoever bought way out of the money Bear Stearns PUTs “knew” something and illegally acted on it. I agree with this.

2. The same institution that bought the PUTs was illegally shorting shares. I think this is a safe assumption.

3. There is a conspiracy to protect those evil doers. I do not agree that there is a conspiracy to protect the short sellers who attacked Bear Stearns any more than there was a conspiracy to protect Bernard Madoff before his scheme blew up. What “protects” them is Wall Street culture, and it’s no conspiracy…it’s common knowledge.

Shedlock then attempts to explain how the market really works via four statements of fact which he expects will undo my arguments, but which in reality only support them.

Here again, I present Shedlock’s facts verbatim, followed by the information he apparently did not have when he originally wrote them, in blue italics.

Fact #1: When someone buys PUTs the market maker or counterparty who sold them is short those PUTs. This is a mathematical statement of fact. This is 100% truth.

Fact #2: The market maker who sold the PUTs, shorts stocks as a hedge against those short PUTs.
This is also 100% truth, and an indispensible component of illegal naked short selling, which requires the options market maker to sell the stock naked short to the fund buying the puts. This is part of the married put strategy we’ve claimed from early on facilitates illegal short selling. As far back as 2003, the SEC expressed concern about married put strategies as a means of circumventing multiple market regulations. In this 2007 paper, an economist explains how a combined strategy of married puts and reverse conversions provided the engine that powered the naked shorting epidemic that grew unabated until changes were finally made in the wake of Lehman’s demise.

Fact #3: The lower the share price, the more shares the market maker has to short to stay delta neutral. Also true.

Fact #4: Market Makers are not governed by naked shorting rules. Again, Shedlock steals my line. Prior to the repeal of the options market maker (OMM) exception of Regulation SHO, OMMs were not bound by the locate and delivery requirements of that rule. So, it’s entirely predictable that options trading would play a key role in any effort to circumvent Reg SHO.

The existence – and illegality – of these kinds of tactics are documented in this November 2009 administrative action brought by the SEC against Rhino Trading and Fat Squirrel Trading (one of only two enforcement actions specifically alleging naked short selling filed in the Commission’s history). In it, you’ll learn how reverse conversions and “resets” (the call-based alternative to the married put) were used to illegally manipulate other stocks down.

At this point, Shedlock has spelled out the entire philosophical foundation for his disagreement with me, and yet we’re apparently in the awkward position of not disagreeing about any of the parts that really matter. The actual disagreement seems to be based on our interpretations of the implications of these facts, in my case informed by a slightly more detailed (though not very broadly-applicable) knowledge of the tactics used by illegal stock manipulators. That Shedlock is not familiar with these tactics speaks very well of him as an investment manager, in my opinion.

So, while Shedlock claims, “the [options] market makers shorting Bear Stearns did so for purely mathematical reasons, to remain delta neutral” I assert that this necessity, combined with their exemption from Regulation SHO’s locate and delivery requirements in place at the time, made them the perfect counterparty to a short-selling hedge fund seeking to warp the market for Bear Stearns stock through the generation of artificial supply.

Shedlock further asserts that Bear’s demise was the inevitable product of its own greed and toxic balance sheet. I respond by agreeing that Bear probably was destined to go under, and in capitalism, that’s ok. However I further point out that Bear had $18-billion in cash on hand when the assault began, and so the process should not have taken just one week. In a civilized world, even when someone is on their deathbed, it’s not ok to hasten death through forceful application of the pillow; and particularly not when the incentive for doing so is pecuniary.

As promised, the space to follow is reserved for Mr. Shedlock to offer his rebuttal.

==============================================================

.

I’m particularly eager to get that batch, because it has the capacity to confirm or rule-out my ability to predict the future.

See, I believe I know, to within a few percentage points, how some of that delivery failures data — up to this point supposedly known only to the DTCC and SEC — will read.

But instead of going mad waiting for it to be posted, I’m going to very publicly make my prediction here and now, and then follow up with the actual numbers once published. I shall then take my clairvoyant victory lap around the tiny office where I sit.

Therefore, I do predict the following:

With a margin of error of +/-2.5%, Shares of Sears Holdings Corporation (NASDAQ:SHLD) will be shown to have experienced CNS delivery failures of the following magnitudes on the indicated dates:

1/29/2010 879,444
1/28/2010 873,222
1/27/2010 870,570
1/26/2010 851,904
1/25/2010 848,742
1/22/2010 865,266
1/21/2010 857,106
1/20/2010 1,535,508
1/19/2010 1,540,914

Please check back often between today and tomorrow (or whenever the SEC gets around to posting the final numbers) to learn how accurate my predictions turned out to be, how I arrived at them, and why this is very bad news for our capital markets.

(note: on 2/22 at 8:27am MST I adjusted my prediction)

Things become all the more weird when you consider that regulators and law enforcement do almost nothing to stop naked short selling, even though a growing number of prominent people – everyone from U.S. Senators to George Soros – insist that criminal naked short sellers helped take down Bear Stearns, Lehman Brothers, and the American financial system. Then there’s the weird fact that anybody who tries to shed light on this weird state of affairs is quickly subjected to smear campaigns that are…weird.

Anyway, message to Matt Taibbi: Welcome to our world.

Taibbi, as many people know, is the star reporter who published a major expose about naked short selling in the most recent issue of Rolling Stone magazine. In addition, he has published a few blogs providing more evidence to support his claim that illegal naked short selling is a big deal and it’s pretty “hilarious,” as he puts it, that the government hasn’t prosecuted the people who might have helped crash the financial system.

In one of his blogs (which you can read here), Taibbi posts a video that seems to show a day trader conducting a short sale of stock in an unnamed big bank through a brokerage called Penson Financial. The SEC says that short sellers have to have “reasonable grounds” that they can locate actual stock to deliver to their buyers. As Taibbi rightly points out, this is a “very  funny piece of regulatory policy – asking greedy ass financial companies to determine what to them is a ‘reasonable’ effort to follow the rules. “

At any rate, if you believe what you see in Taibbi’s video, Penson Financial gave that day trader a phony “locate” on quite a few of the unnamed big bank’s shares. In fact, the video seems to show Penson Financial confirming that it had “located” many billions of the unnamed big bank’s shares – altogether, five times as many shares as were then in circulation. In other words, it seems that if this trader had had the inclination and the funds, Penson would have accepted a massive naked short sale, helping the trader flood the market with billions upon billions of shares that simply did not exist.

This is rather important, because Deep Capture has reviewed evidence showing that little Penson Financial and one other relatively unknown firm were by far the biggest traders in financial stocks in the first nine months of last year, handling more than 80 percent of volume. To repeat, Penson Financial, a little firm in Dallas, Texas, and one other relatively small firm handled by far the biggest volume of trading in the stock of all those big banks that collapsed last year, leading to the worst financial crisis since the Great Depression. When it came to clearing trades in financial stocks, Penson was bigger than Goldman, bigger than Merrill, bigger than every major brokerage on Wall Street.

We do not know for certain that the trading through Penson was naked short selling. We know only that naked short selling accounted for much of the overall trading last fall in companies like Lehman Brothers. And we know that a preponderance of the overall trading went through Penson. Perhaps Penson carefully weeded out the naked short sellers, in which case it handled almost all of the trading in financial stocks except for naked short selling. But if Taibbi’s video is any indication, Penson was certainly willing to locate stock that did not exist.

If I have anything to add to Taibbi’s terrific reporting, it is this: Penson Financial’s vice president in charge of stock clearing (that is, the head of the division that appears to have located stock that did not exist) is a man named Christopher Sandel. From 1985 to 1995, Sandel was a top executive at Adler Coleman, best known for being the clearing firm to the Genovese Mafia family.

Adler Coleman famously went bust when its top customer, the Genovese-controlled brokerage Hanover Sterling, self-imploded in one of the greatest naked short selling scandals of all time. Several traders tied to the Gambino crime family were charged with naked short selling companies that were underwritten by Hanover. That the Genovese Mafia brokers at Hanover were not charged in this case seems odd, because the most likely scenario is that the Genovese underwrote hapless companies, pumped their stock prices, and then called in the Gambinos to vaporize the companies, with everybody profiting on the way down.

Anyway, when some of America’s biggest financial companies collapsed under a barrage of short selling last fall, an enormous chunk of that trading was being cleared by a fellow who used to work for a company that seemed to specialize in clearing trades for the Mafia. Should this concern us? Might the Mafia have played some role in the collapse of the financial system? If I were more heavily armed, I would venture an opinion.

Now, of course, there is a concerted effort to portray Taibbi as a sucker, and his video as a fake. One blogger who has suggested as much is Gary Weiss, a former BusinessWeek reporter. As we have documented elsewhere on Deep Capture, Gary Weiss is a corrupt pseudo-journalist whose sources have included naked short sellers with ties to the Mob. Among Gary’s favorite sources were John Fiero (fined $1 million in Hanover Sterling scandal), Anthony Elgindy (currently serving an 11 year prison sentence for short selling crimes and alleged to have had his finger sawed off by Russian mafiosi who were concerned that he would become a government informer), and Manuel Asensio (who once worked for a Mafia-controlled brokerage called First Hanover).

Weiss has reported extensively on the Mafia’s infiltration of Wall Street, but he has, for years, insisted that only conspiracy theorists believe naked short selling is problem. He wrote a great deal about Hanover Sterling, but not once did he mention that naked short selling was central to that case. In his book, “The Mob on Wall Street,” Weiss told the story of a Genovese Mafia broker, and mentioned that this Mafia broker claimed to clear his trades through none other than…Penson Financial.

But, of course, Gary insisted that the Mafia broker must have been lying, because Penson is a “legitimate firm.”

Meanwhile, a blog called ClusterStock has also suggested that Taibbi’s video is a “hoax.” Taibbi has written a fine rebuttal to that claim (which you can read here), so I have nothing to add, except that ClusterStock was founded by Henry Blodget, who was famously charged with securities fraud in 2002, and by the former co-owners of DoubleClick, a company that was once defrauded by the Colombo Mafia family. DoubleClick was never charged with any crimes, as it was, alas, the victim.  Such is the sad fate of many firms that  have business dealings with the Mafia (of course, this fate may be avoided by adhering to a simple dictum: “Avoid having dealings with the Mafia”).

I tell you this not because I think there is some kind of conspiracy, but  merely because I am fascinated by the always colorful biographies of people who attack those who seek to expose the crime of naked short selling. Blodget is, by all accounts, a reformed criminal, and I’m sure the other people at ClusterStock  are law-abiding people. Gary Weiss would be perfectly innocent, too — except that he’s an out-and-out fraud.

Recently, Deep Capture reporter Judd Bagley revealed that Weiss was the anonymous author of a blog on the popular website Daily Kos. This blog, of course, denied that naked short selling is a crime, while smearing those who said otherwise. To support its smears, the blog, written by the anonymous Gary Weiss, referred readers to another blog, written by none other than Gary Weiss.  Indeed, Gary Weiss has had a great many phony on-line aliases, and all of these Gary Weiss aliases proclaim that Gary Weiss is right and great.

In a variation of this on-line chicanery, ClusterStock’s writers littered the comments section of Taibbi’s blog with allegations that his video was a “hoax.” To support these allegations, the ClusterStock writers provided links to another blog…ClusterStock. Presumably, Gary Weiss will also provide links to ClusterStock. Oh wait, he already did that.

Meanwhile, Penson Financial, has written a letter to the SEC, suggesting that Taibbi’s video was (what else?)…”a hoax.”  In the letter, Penson Financial, which was fined in 2006 for naked short selling, promises that it does not engage in naked short selling.

The SEC no doubt believes this.

Taibbi writes:

“On Tuesday, March 11^th, 2008, somebody – nobody knows who – made one of the craziest bets Wall Street has ever seen. The mystery figure spent $1.7 million on a series of options, gambling that shares in the venerable investment bank Bear Stearns would lose more than half of their value in nine days or less. It was madness – “like buying 1.7 million lottery tickets,” according to one financial analyst.”

Bear’s stock would have to drop by more than half in a matter of days for the mystery figure to make a profit. And that is what happened.

As Taibbi explains, “the very next day, March 12, Bear went into a free fall…Whoever bought those options on March 11^th woke up on the morning of March 17^th having made 159 times his money, or roughly $270 million. This trader was either the luckiest guy in the world, the smartest son of a bitch ever or…Or what?”

Taibbi speculates (as has Deep Capture) that these options might have been purchased by somebody who was abusing the options market maker exemption to engage in illegal naked short selling. And Taibbi goes beyond speculation to state, as an obvious fact, that illegal naked short selling helped bring Bear Stearns to its knees.

Presumably operating under that assumption, the SEC issued more than 50 subpoenas to Wall Street firms in the wake of Bear’s collapse, but “it has yet to indentify the mysterious trader who somehow seemed to know in advance that one of the five largest investment banks in America was going to completely tank in matter of days.”

Taibbi continues: “The SEC’s halfhearted oversight didn’t go unnoticed by the market. Six months after Bear was eaten by predators, virtually the same scenario repeated itself in the case of Lehman Brothers – another top-five investment bank that in September 2008 was vaporized in an obvious case of [naked short sellers engaging in] market manipulation. From there, the financial crisis was on, and the global economy went into full-blow crater mode.”

Taibbi notes that there were many other factors that made the economy weak. But he says that naked short selling is what pushed Bear and Lehman over the edge. If it weren’t for naked short selling – a massive “counterfeiting scheme,” in Taibbi’s words — those banks would likely have survived, and we might have avoided an all-out financial catastrophe.

This cannot be stressed enough. Criminals deliberately destroyed two of America’s biggest investment banks, precipitating the greatest financial cataclysm since the Great Depression. And the government has done absolutely nothing to bring those criminals to justice. In fact, as Taibbi makes clear in his story and on his blog, the most likely culprits are feted by top government officials in closed door meetings.

I’d call this the biggest financial and political scandal in the history of this country.

Certainly, it is, as Taibbi writes, “one of the most blatant cases of stock manipulation in Wall Street history.” Certainly, it is, as Taibbi writes, “the two biggest murders in Wall Street history.” And, certainly, it is odd that this very big story has appeared in Rolling Stone, but has yet to be covered by a single mainstream news publication.

The Wall Street Journal, The New York Times, Fortune, BusinessWeek – they have all known about naked short selling since Deep Capture reporter Patrick Byrne began hollering about it in 2005. But none of them write about it. Instead, we find a competent financial journalist, and the only major story about one the greatest financial crimes of all time, published in a slightly alternative magazine about music.

I worry for the Republic.

* * * * * * * *

Too many stinging disappointments, I suppose.

Too many instances of people behaving badly, to be certain.

But as they say, there’s some value in expecting the worst…you’ll never be disappointed.

And so it was with today’s second and concluding session of the SEC’s roundtable on securities lending and short selling: I expected the absolute worst, but in the end was pleasantly surprised to find that it wasn’t quite as bad as I feared.

That’s not the same as proclaiming it a good thing, because it was not. Indeed, I stick by yesterday’s characterization of the event as farce with a pre-determined outcome.

Having said that, I was deeply impressed by two surprises I clearly had not anticipated. And I’ll get to those in a moment.

But first, an overview.

There were two panels. The first examined proposed pre-borrow and hard locate requirements — keys to closing two of the most dangerous remaining loopholes in the US stock settlement system. The second panel examined proposals requiring enhanced disclosure of short selling data — a good idea but ultimately one that would be much less necessary were the proposals discussed in the first panel enacted.

I’ll start with the second panel, which surprised me by coming down overwhelmingly in favor of more transparency in short selling.

Georgetown University Professor James Angel pointed out that greater disclosure would essentially be doing legitimate short sellers a favor, by vindicating them in cases when they are incorrectly accused of manipulation in response to stocks dropping in value.

David Carruthers, of short selling analytics firm Data Explorers, supported greater transparency in short selling where the goal was to “prevent market abuse and prevent the development of a false market, or to prevent situations where market participants take advantage of a vulnerable company.”

Richard Gates, founder of short selling hedge fund TFS Capital, denied that shorting exacerbated the onset of the current financial crisis, but went on to concede that there should be greater disclosure parity on the short and long sides of market activity.

Michael Gitlin of investment manager T. Rowe Price echoed the position of Professor Angel in saying real time reporting of short versus long sales would result in the “demystification of short selling,” adding, “The ongoing debate of what caused an individual security to decline would largely disappear with this added level of transparency.”

As the lone issuer represented on the panel, Jesse Greene, Vice President of Financial Management at IBM, was enthusiastically in favor of a general overhaul of the SEC’s short selling regulatory framework, including public disclosure of short positions, in order to “improve market stability and restore investor confidence.”

Joseph Mecane, Executive VP at NYSE, noted that market fragmentation has made it more difficult to detect manipulation, requiring regulators have access to more short selling data in order to better conduct market surveillance.

In other words, the second panel was a slam dunk in the right direction.

The first and ultimately more meaningful panel, on the other hand, was the Yin to the second panel’s Yang.

Appropriately enough, Managing Director of the Equities Division at Goldman Sachs (NYSE:GS) William Conley kicked things off, lamenting that “both the pre-borrow and hard locate requirement would require significant infrastructure builds on the part of the industry as well as its participants.”

By “infrastructure builds”, Conley is referring to the development of new software able to track down real shares for short sellers to borrow. He seems to have forgotten three things:

1. When there’s money to be made, Goldman Sachs has a rare talent for developing extremely complicated software. Could it be that Conley never met former co-worker Sergey Aleynikov?
2. LocateStock.com, then a bootstrapping startup, developed software that accomplishes precisely the same task Conley regards as so burdensome, on a shoestring budget.
3. If Goldman Sachs has enough cash on hand to spend nearly $12-billion in employee bonuses this year, it can probably set a couple hundred thousand aside to write some crumby software.

As I predicted yesterday, much of the balance of Conley’s mic time was spent echoing the anti-reform talking points currently being circulated on Capitol Hill by his employer’s army of lobbyists — in some cases, verbatim.

William Hodash, Managing Director at DTCC, took us on a trip to his organization’s mindset circa 2005 by pointing out that fails to deliver are not necessarily evidence of naked short selling. With one foot remaining firmly in 2005, another in 2009 and a third in a pile of his own illogic, Hodash then said that the reduction in fails observed before and after the SEC’s implementation of Rule 204 “may be relevant to the discussion of whether naked short selling remains a problem.”

No, you didn’t miss anything. That’s what he said, with all remaining panelists basically pleading some variation of the on his and Conley’s approaches.

With one very prominent exception: Dennis Nixon, Chairman of International BancShares Corporation (NASDAQ:IBCA).

Looking at the program, I had assumed that IBCA’s role on the panel was that of a broker or other market intermediary. Well I was very wrong. IBCA was there in the role of an issuer targeted by naked short sellers, and Nixon very poignantly expressed the anguish of someone in his position, after a 45-day long bear raid removed $1.2-billion in IBCA shareholder value.

“And I think it was all attributed to this predator-type short selling that goes on in this market today that’s uncontrolled. It’s unbelievable,” Nixon said.

That was the first surprise.

The second surprise came from an even less likely source: Commissioner Elisse Walter.

Mostly silent throughout the previous day’s panels, today Walter made it clear that she’s not buying the excuses offered by industry representatives insisting this problem is too much for them to tackle.

“I’m sort of surprised that the industry hasn’t come up with a solution, particularly as this controversy has continued to swirl and does not go away,” Walter said, adding that by failing to address the issue, the industry is essentially passing the cost of non-compliance on to the SEC’s own Division of Enforcement.

I think she’d make a stronger case had the Enforcement Division brought more than two cases against naked short sellers in its entire history, but that’s a topic for another post.

The bottom line is, this panel was undeniably stacked against any additional meaningful steps to limit illegal naked short selling, but the contributions of Dennis Nixon and Elisse Walter were as welcomed as they were unanticipated.

The entire affair could have been much better, but also could have been much worse.

Deep Capture goes to Washington.

(Washington, DC) The SEC’s roundtable on securities lending and short selling got started today, and Deep Capture was there.

What follows is my assessment, based on my observations thus far.

In the simplest terms, I’d say the situation at the SEC is one of extreme disconnection. This is an agency that has completely lost track of its founding mission.

The day consisted of four panels, all dedicated to examining different aspects of securities lending. The panelists included one academic, one public employees’ pension fund manager, the CEO of FINRA, and 20 representatives of hedge funds and brokerages or companies that provide services to hedge funds and brokerages.

Not a single representative or advocate of retail investors had a voice on any panel, and the substance of the panelists’ comments was consistent with the thinking that obviously called them all together: the discussion never got beyond reforms to benefit the institutions that get rich from lending out the shares entrusted to them by the rest of us.

Nor did retail investors get any more than a passing reference in any other context. The industry was there to talk about the needs of industry. Period.

The result was eight hours of possibly the least interesting discussion I’ve voluntarily endured. In fact, it more resembled two dozen high school book reports on a handful of facets of a single industry, as the same thing was said over and over in the lest interesting way possible.

For eight hours.

Meanwhile, the subject that really matters: illegal naked short selling, is scheduled for just three hours tomorrow (including a break!), with panelists hailing from four hedge funds, Goldman Sachs (NYSE:GS), DTCC, the Security Traders Association, NASDAQ, NYSE, one academic, and one fish-out-of-water from IBM.

Is there any question how those panels are going to come down on the issue?

This entire exercise, I’m nearly prepared to declare, is little more than a farce.

Lest I leave you with the impression that everything was devoid of meaning, allow me to recount one of those moments of cosmic synchronicity that make days like today all worthwhile.

It happened during the fourth panel. Specifically, during the opening remarks given by Leslie Nelson (yes, a male, but sadly no, not the guy from The Naked Gun movies), Managing Director of Global Securities Lending at Goldman Sachs.

Just as Mr. Leslie Nelson was beginning to talk, about 15 of you emailed me a link to Matt Taibbi’s recent post where he announced that naked shorting will be a major component of his upcoming piece in Rolling Stone.

Included in that post was a link to a pamphlet apparently being circulated broadly on Capitol Hill by Goldman Sachs lobbyists, intent on preserving the status quo with regard to loopholes permitting illegal naked short selling. Trusting my audio recorder not to miss anything, I decided to tune Mr. Nelson out slightly to read the words of his notorious employer.

In the Goldman pamphlet, the first sub-point of bullet point one reads:
“Rule 204 of Regulation SHO has been effective at reducing fails in the marketplace.”

At precisely the same time read that line, I heard Nelson read the following from his prepared statement (prefatory to what — consistent with the rest of the day’s panel — had nothing to do with delivery failures):
“Rule 204 has been undeniably effective at bringing US equities fails to levels that are truly de minimis.”

See…I read and heard those lines at precisely the same moment.

It was as though the Goldman Sachs government relations team had briefly hijacked my eyes and ears.

It’s also indicative of how very seriously Goldman is taking this challenge to what is likely one of that company’s most plumb sources of revenue.

Finally, I’d say it’s predictive of the message what we can expect to hear repeated over and over again as the issue makes its was earnestly through Congress and flaccidly through the SEC.

You know, I do not drink, but if I did, I’d suggest everybody take a shot whenever they hear that phrase repeated during the three short hours (including a break) of the roundtable’s second and final day. That might just make the thing tolerable.

The Bizarro World Code

Within minutes of my introduction to the world of short selling hedge funds, I encountered the analogy that remains the best suited to describe the truth to which they subscribe: Bizarro World.

A planet that appears from time to time in the DC Comics universe, Bizarro World is noteworthy for its utter opposition to everything associated with reality on Earth (in fact, another name for Bizarro World is Htrae – “Earth” spelled backwards).

Bizarro World made very infrequent appearances in the DC Comics universe; however what few insights we’ve been able to gain have been telling.

For one, we know that the residents of Bizarro World adhere to a simple moral code: “Us do opposite of all Earthly things! Us hate beauty! Us love ugliness! Is big crime to make anything perfect on Bizarro World!”

Bizarro Superman

For another, consistent with its black-is-white nature, the alpha-superhero of Bizarro World – a Superman-like figure appropriately named ‘Bizarro’ – is in fact a super villain, and one of many.

Fortunately, or possibly unfortunately, the Bizarro World of short selling hedge funds sits side-by-side with our own. Yet, true insights into how it actually operates have been startlingly rare.

Possibly the best behind-the-curtains view came in December of 2006, with Jim Cramer’s infamous admission as to how short selling hedge funds do (and indeed, according to Cramer, “must”) operate, moving the Bizarro World citizenship of that group from theory to undeniable fact.

See for yourself:

Cramer: “You can’t foment. You can’t create yourself an impression that a stock’s down. But you do it anyway because the SEC doesn’t understand it. So that’s the only sense that I would say that it’s illegal.”

Bizarro translation: “Us do opposite of all Earthly things! Us can break law to make money because regulator not understand regulations!”

Cramer: “Look what people can do. I mean that’s a fabulous thing! The great thing about the [stock] market is that is has nothing to do with the actual stocks. Look, over maybe two weeks from now the buyers will come to their senses and realize everything they heard was a lie…”

Bizarro translation: “Us hate beauty! Us pervert capital markets to make them hostile to small, promising businesses and technologies! Us stock market has nothing to do with actual stocks!”

Cramer: “These are all what’s really going on under the market that you don’t see. What’s important when you’re in that hedge fund mode is to not do anything remotely truthful – because the truth is so against your view, that it’s important to create a new truth to develop a fiction.”

Bizarro translation: “Us love ugliness! Us hate truth! Us prefer fiction!”

Cramer: “I think that it’s important for people to recognize the way that the market really works is to have that nexus of ‘hit the brokerage houses with a series of orders that can push it down’, then leak it to the press, and then get it on CNBC (that’s also very important), and then you have kind of a vicious cycle down. It’s a pretty good game.”

Bizarro translation: “Is big crime to make anything perfect on Bizarro World! Us make money by wrecking public companies! And here on Bizarro World, Jim Cramer not even pretend to be friend of small investor! Oh yeah…CNBC official network of Bizarro World!”

(Lest any suppose these clips have been taken out of context, I strongly encourage everybody to download and view the 10 minute conversation in its entirety.)

On Bizarro World, villains are treated like celebrities while the law-abiding are scorned and ostracized. So it should come as no surprise that on CNBC (the official network of Bizarro World), short selling hedge fund managers are called “titans” while those who question them are dismissed with a wink and a smirk.

Of course, this would seem consistent with the seemingly inverted reality that is short selling, where – as opposed to traditional investors who earn profits when they buy low and later sell high – shorts aspire to do the same by first selling high and then buying low.

While on the surface short selling might appear to have been invented on Bizarro World, that’s not true. Shorting is (as has been stated time and again on this blog) a healthy part of a normal market.

What was invented on Bizarro World, however, is shorting’s insidious doppelganger: naked short selling, which is a practice ripped straight from the Bizarro World welcome guide. Unlike legitimate short selling, which requires first borrowing the shares one sells short, naked shorting skips that step, allowing criminals to sell not only something they do not own, but something that does not even exist, except as a tradable electronic ledger entry which they themselves conspire with corrupt brokerages to create.

This, in turn has the effect of artificially increasing the supply of a company’s shares. In other words, on Earth, only companies get to issue stock, whereas on Bizarro World, it’s the naked short sellers that issue shares of a company’s stock, with impunity, sometimes in quantities rivaling the number of legitimate, company-issued shares in circulation (with the expected impact on share price).

Or, should I say, naked short sellers used to be able to do this.

The truth is, since shortly after the onset of the economic crisis naked short sellers themselves helped to spark, naked shorting has become an increasingly difficult crime to commit.

The result?

Despite the fact that we’re in the midst of an epic bear market – when one would normally expect short sellers to thrive – the biggest short selling hedge funds are getting hammered.

Today, Reuters business writer Svea Herbst-Bayliss has a shocking overview of the breadth of the situation, which she begins by comparing to Waterloo – the battle which forever put an end to Napoleon’s aspirations of world domination.

Based on insiders’ insights into forthcoming letters to investors explaining their performance over the first and second quarters of 2009, Herbst-Bayliss predicts that “To anyone considering hedge fund investments in the coming months, the data will illustrate that these managers who cashed in on last year’s financial markets crash now rank as the $1.4 trillion hedge fund industry’s worst performers.”

Specifically, Herbst-Bayliss notes, “In the first six months of 2009 [short selling hedge funds] lost 9.38 percent, compared with the 9.55 percent that other hedge funds gained.”

Most notably, the story quotes Brad Alford, a professional hedge fund advisor and investor, who says, “Every few years short-sellers have their day in the sun. Then things revert to normal where the markets rise and life becomes so difficult for them that many just go out of business,” he added.

In case you missed it, you might want to re-read Alford’s quote to make sure you catch what makes it so telling: that a rising market can be bad for short sellers.

But how can that be, given the recently-ended bull market – possibly the greatest in economic history – saw short selling hedge funds such as SAC Capital, Kynikos Associates and Third Point Capital experience mind-boggling growth, while a month-long rise in what is otherwise shaping up to be one of the greatest bear markets in economic history (when the shorts should be thriving) may prove to be their ultimate doom?

Talk about Bizarro World investing!

The difference, I suspect, is naked short selling: a crutch-like tool that allowed the shorts to defy gravity while the market soared, the effective removal of which has left them atrophied and uncoordinated when forced to fend for themselves in a market where capable, legitimate short sellers should thrive.

Blue vs. Green Kryptonite: Click to see full image

Or maybe a more apt metaphor is that of Kryptonite, the green version of which makes Superman weak and Bizarro strong, while the blue version has the opposite effect. For a long time, a captured media and SEC equipped short selling hedge funds with a big, fat slab of green Kryptonite, which their own hubris has caused to be replaced by a bit of the Bizarro-toxic blue stuff.

Will July of 2009 be the short sellers’ Waterloo?

Will short selling hedge funds’ greed simply assume another form?

Will the economy recover before it’s too late to matter?

Find out what happens in the next episode of Deep Capture!

In the end, we settled on the following:

“Entropy increases” and “The pendulum swings.”

The first sentence is a reference to the Second Law of Thermodynamics.

The second sentence is a reference to the fact that cultural trends will always increase in pervasiveness and acceptance until some limit is broached, at which time opposing forces will be applied that cause society to respond with increasing negativity toward that trend. And, as with an actual pendulum, the higher the upswing, the more forceful the push back will be.

How true both are.

I first encountered the market reform movement near the end of 2005. Over the months that followed, I witnessed the following:

1. An SEC staffer in San Francisco subpoenaed the communications of Jim Cramer, Herb Greenberg, Bethany McLean, Carol Remond and a handful of other “journalists” suspected of colluding with Gradient Analytics and short selling hedge fund Rocker Partners, only to have SEC Chairman Chris Cox personally sabotage the effort. This was followed up almost immediately by the SEC vindictively subpoenaing Patrick Byrne.
2. FOIA requests filed with the SEC intended to give some sense of the scope of the delivery failure problem were regularly denied or spitefully filled with minimal accompanying explanation.
3. Numerous brutal articles were published attacking opponents of naked short selling – Byrne primarily among them – under the bylines of (surprise) Jim Cramer, Herb Greenberg, Bethany McLean, Carol Remond, Joe Nocera, and Roddy Boyd.
4. Audio tape captured by a market reform operative who covertly accessed a panel discussion featuring Herb Greenberg, Joe Nocera and Dan Colarusso (then Roddy Boyd’s editor) hosted by the Society of American Business Editors and Writers. The theme of the discussion was essentially “How do we deal with these lying anti-naked short selling bloggers who are so critical of us?” Among other things, the tape caught Joe Nocera saying (to loud applause) he felt life was too short to bother understanding whether naked shorting is actually a problem, and Dan Colarusso saying he and his newspaper had the capacity to “crush” Patrick Byrne.
5. An all-out PR offensive launched by the Depository Trust & Clearing Corporation (DTCC) attacking opponents of naked short selling.
6. The emergence of Gary Weiss, an ostensibly credible former business journalist and blogger, bursting onto the scene, proclaiming naked short selling beneficial and its opponents crazy.
7. The hijacking and distortion of the Wikipedia article on naked short selling by whom we would soon learn was none other than Gary Weiss. Given journalists’ well-documented over-reliance on Wikipedia, this was undoubtedly a key factor in our difficulty getting them to provide more balanced coverage of the issue.
8. A special session of the Utah Legislature which, catching the banks flat-footed, resulted in passage of a law requiring brokerages with operations in Utah to promptly disclose stock delivery failures. But before it could go into effect, and after the prime brokers managed to rally their armies of lobbyists, the law was handily repealed.
9. Unprecedented growth of companies on the Reg SHO Threshold Securities list, indicating that, contrary to the intended aim of Regulation SHO, naked shorting was becoming increasingly prevalent.

On balance, it was a very dark time for the market reform movement, as every charge was followed by a blistering counter-charge, and every lunge answered by a quick parry. More than once, I recall hearing even the staunchest market reformers openly question the capacity of a rag-tag band of revolutionaries to counter the enormous influence and resources brought to bear by the hedge funds and prime brokers who were getting rich from the practice of manipulative naked short selling, and I couldn’t help but wonder whether I’d picked the wrong battle.

That’s not to say I ever doubted the correctness of the cause – only the correctness of my decision to join a fight that sometimes seemed impossible to win and certain to result in damage to my reputation as it had to Patrick Byrne’s and so many others’.

But in those moments of doubt, I’d remind myself of an eternal truth: the pendulum swings.

In other words, as dark as those days were, there would invariably be restraining forces applied to help slow – and eventually stall and even reverse – the momentum built up by decades of Wall Street villainy and the deep regulatory capture of the institutions intended to counter it.

What we could not have realized – as such perspective only comes with time – is that we (meaning, you, me, and everybody else who’s taken steps to do something about illegal naked short selling) were in fact the very restraining forces so many of us were expecting to arrive, cavalry-like, from some unknown quarter, and that as dark as those days seemed, they appeared quite bright to those who had endured the 1990s and early part of the current decade, when the practice persisted, without restraint, like a drunken orgy.

Of course, the event that finally brought the pendulum to a decisive halt and reversal was the current economic crisis, which saw the term “naked short selling” dragged into the popular lexicon (as determined by Yahoo! listing it as one of its five most popular search terms in September of 2008).

Since then, as the link between naked short selling and the beginning of the crisis itself has been solidly established, valiant members of Congress – most notably Delaware Senator Ted Kaufman – have dragged the issue of naked short selling into the political lexicon, as well.

Where are we today?

1. The SEC recently enacted permanent restrictions on illegal naked short selling, which include greatly enhanced disclosure of delivery failures and shorting activity.
2. Today, the SEC brought its first enforcement cases against illegal naked short selling.
3. Also today, FINRA expelled a member firm for engaging in illegal short selling.
4. Jim Cramer has been deeply and publicly shamed. Herb Greenberg is now a ‘consultant’. Bethany McLean has left business journalism. Dan Colarusso continues looking for steady employment. Roddy Boyd, Carol Remond and Joe Nocera all retain their former positions, but seem to steer clear of anything resembling the issue of naked shorting.
5. The DTCC is mum on the issue as well.
6. Gary Weiss – since abashed and banned from Wikipedia – sinks ever deeper into obscure irrelevance while the Wikipedia article on naked short selling that he once controlled has been liberated and made to read nearly as it should.
7. Substantive legislation with the capacity to end illegal naked short selling and other short-side market abuses once and for all is currently working its way through Congress.
8. As of today, the Reg SHO Threshold Securities list is 23% shorter than it was on the day I met Patrick Byrne (and 90% smaller than it was at its height in July of 2008), and is nearly devoid of the kinds of promising, well-capitalized companies whose inclusion used to be a sure sign of an impending bear raid.

These are all developments that seemed impossible in the dark days of 2006.

But here we are.

Yes, the pendulum is now unambiguously swinging in our direction, but the job is not done. Indeed, we can only be assured of progress to the extent that we each recognize our responsibility to continue pushing.

What follows is PART 13 of a 15-PART series. The remaining installments will appear on Deep Capture in the coming days, after which point the story will be published in its entirety.

Click here to read PART 1

Click here to read PART 2

Click here to read PART 3

Click here to read PART 4

Click here to read PART 5

Click here to read PART 6

Click here to read PART 7

Click here to read PART 8

Click here to read PART 9

Click here to read PART 10

Click here to read PART 11

Click here to read PART 12

Where we left off, we had learned that on March 29, 2007, an FDA advisory panel overwhelmingly voted to approve Provenge, a vaccine Dendreon developed for prostate cancer. As a result, most financial analysts and investors believed that Dendreon had a promising future.  However, ten hedge funds (out of a universe of 11,500 hedge funds) held large numbers of Dendreon put options (bets against the company), suggesting they had expected that Dendreon would be derailed. At least seven of those hedge funds can be tied to Michael Milken or his close associates.

We had also learned that Milken himself stood to profit if Dendreon were to experience unexpected problems receiving FDA approval. This is because Milken was the early financier and principal deal maker for ProQuest Investments, a fund that (along with an affiliate) controlled a company called Novacea, which was one of Dendreon’s competitors in the race to produce a new treatment for prostate cancer. Meanwhile, Lindsay Rosenwald (a Milken crony who once helped run a Mafia-linked brokerage called D.H. Blair, which specialized in pumping and dumping fake biotech companies) controlled Cougar Biotechnology, which was Dendreon’s second competitor in the race to develop a treatment for prostate cancer.

We had learned further that Milken’s “philanthropic” outfit, the Prostate Cancer Foundation, which appears to act in concert with Milken’s investment fund, ProQuest, had supported Novacea and Cougar, neither of which had shown that their treatments were safe or effective, while turning its back on Dendreon.

In addition, we had learned that in April, 2007, Dr. Howard Scher, who was an executive and director of ProQuest, and the chairman of the Prostate Cancer Foundation’s “Therapeutic Consortium”, spearheaded an unprecedented lobbying effort to convince the FDA to deny approval to Dendreon’s treatment – the first time in history that the FDA had gone against an advisory panel’s recommendation to approve a drug destined for dying patients.

In the days before and after the lobbying effort, Dendreon was subjected to a blistering attack by naked short sellers who illegally flooded the market with millions of phantom shares to help drive down the company’s stock price. This criminal naked short selling continued intermittently for much of the next two years, while other events conspired to hobble Dendreon, a company that had completed multiple clinical trials that strongly suggested that its product, Provenge, was capable of lengthening the lives of thousands of men with prostate cancer….

* * * * * * * *

In December 2007, three U.S. Congressmen — Mike Michaud (D-Maine), Dan Burton (R-Indiana) and Tim Ryan (D-Ohio) — called on the House Commerce Committee to investigate why the FDA failed to approve Dendreon’s treatment for prostate cancer. Referring to Dr. Scher and his ally, Dr. Hussain, the lawmakers said in a letter that “there are reasons to believe that serious ethics rules were violated by two FDA advisory panel members in their decision [to vote and lobby against Dendreon] and that these violations played a role in the subsequent FDA decision not to approve Provenge at this time.”

A bipartisan group of 12 additional Congressmen eventually signed on to the request for an investigation. And in February 2008, as outrage over this scandal spread through the medical community, a group of seven respected doctors, calling themselves “Physicians for Provenge” wrote a letter to the ranking members of the House Commerce Committee, suggesting that the investigation should urgently proceed.

“Please consider why our colleagues and we KNOW that Provenge works and why tens of thousands of men with late stage prostate cancer should be given access to it,” the physicians wrote. Noting the “egregious conflicts of interest” of Dr. Scher and Dr. Hussain, the “Physicians for Provenge” added that the “FDA should be carefully assessing risk versus reward for the treatment of terminally ill patients, rather than ‘gate keeping’ based on outdated statistics, reducing short-term health costs or backroom shenanigans.”

Nonetheless, Commerce Committee Chairman John Dingell denied the requests for an investigation. To justify this decision, Dingell wrote in a letter to the committee that an “investigative hearing prior to an agency’s final decision runs the risk of interfering with the normal regulatory process.”

Apparently, it was fine if FDA-contracted doctors and government officials tied to Michael Milken corrupted the normal regulatory process by obfuscating approval standards (“substantial evidence” versus “proof”) and by drafting unsolicited post-vote letters with back-channel help from a government employee who was weeks away from taking a new job created by Michael Milken.  But investigating such improprieties would corrupt the regulatory process, in the eyes of Commerce Committee Chairman John Dingell.

Dingell also pointed out that “a new law strengthening conflict of interest provisions now governs FDA panels.” Unfortunately, that law was passed in September 2007, some months after Milken’s conflicted allies derailed Dendreon’s application.

In any case, it is not clear that the old conflict of interest provisions were not violated in the Dendreon case. Dr. Scher received a conflict of interest waiver, but in his application for that waiver he did not mention his financial ties to Milken’s ProQuest Investments. There should have been an investigation into why that waiver was granted. And while he was at it, Representative Dingell should have investigated the illegal naked short selling of Dendreon and the “backroom shenanigans” of Milken’s captured officials at the FDA and the National Cancer Institute.

At any rate, while the congressional investigation was being stopped in its tracks, Milken’s Prostate Cancer Foundation was becoming more brazen.

In March 2008, for example, the Prostate Cancer Foundation sent out a peculiar mass mailing. Written by a cardiologist on Prostate Cancer Foundation letterhead, the mailing began, “I’ll never forget the day my 5-year-old son came home from school, worried. One of the other kids told him I was going to die.”

The letter went on to describe the horrors of being diagnosed with prostate cancer. So far, all kosher. But then came the strange part – the charity’s solicitation explicitly promoted a mostly untested experimental treatment that was being developed by a public company that was considered to be one of the few competitors to Dendreon. The treatment was called GVAX, and the company developing it was called Cell Genesys.

The author of the letter noted that during his treatment, he had “learned about some of the groundbreaking research projects supported by the Prostate Cancer Foundation, such as GVAX, a drug now in phase 3 clinical trials that boosts the immune system to fight off prostate cancer cells.”

Notice that the name of the drug – GVAX – was printed in boldface letters, so nobody could miss it. Notice, too, the underlining, which stressed that this treatment (as opposed to others, such as Dendreon’s) was endorsed and supported by the Prostate Cancer Foundation. And, finally, notice the unequivocal statement that GVAX works – that it “boosts the immune system” and is able to “fight off” cancer.

Lest there be any question that Milken was eager to promote GVAX, the Prostate Cancer Foundation, soon after, began distributing flyers at supermarkets and shopping malls with a similar message. “My 5-year-old didn’t want to lose his daddy,” read the flyers, which then proceeded to describe a “groundbreaking” new medicine – GVAX.

At the time, Cell Genesys was nowhere near bringing GVAX to market. It had just finished phase 2 clinical trials on a total of 65 patients. Lab results showed that GVAX might increase prostate cancer antibodies, but they did not show that the immune system was actually boosted in such a way as to better “fight off” cancer or improve survival. Phase 3 trials, which would determine whether GVAX actually improved the health of patients, had just begun.

But if you were an average Joe who read those flyers – or a wealthy Mary who received that solicitation in the mail – you’d be mighty convinced that Cell Genesys was the next big thing in cancer therapy. You might even be tempted to buy its stock.

* * * * * * * *

When Milken’s Prostate Cancer Foundation began distributing his fliers promoting GVAX, a number of hedge funds had accumulated large numbers of shares in Cell Genesys.

One of these was Millennium Management, the hedge fund that had been founded by the fellow who planned to murder Ivan Boesky when it seemed that Boesky might cooperate with the authorities in their case against Milken. Again, Millennium is one of those seven hedge funds that had the foresight to own put options in Dendreon back in March 2007, right before Dendreon’s treatment was unexpectedly scuttled by the FDA.

Another hedge fund with a big stake in Cell Genesys was Forest Investment Management, owned by Michael Boyd, the father of hedge fund shill Roddy Boyd, currently of Fortune Magazine.  Michael Boyd, remember, had previously been involved in two big ventures – one with a former Milken colleague from Drexel Burnham; the other with Santo Maggio, the convicted criminal CEO of Refco Securities.

Hedge fund Perceptive Advisors also held a moderately large stake in Cell Genesys. Recall that Perceptive was then run by Joseph Edelman, who was not only another one of those seven hedge fund managers who held put options in Dendreon, but was also simultaneously serving as a trader for Paramount Capital.

As you might recall, the vice president of Paramount Capital was a former employee of Milken crony Steve Cohen, who was also one of those seven hedge fund managers betting big against Dendreon. The owner of Paramount, of course, is Lindsay Rosenwald, who used to run the Mafia-controlled D.H. Blair with Milken’s former national sales manager, and controlled Cougar Biotechnology, another Dendreon competitor promoted by the Prostate Cancer Foundation.

Another big buyer of Cell Genesys shares was Mazama Capital, a hedge fund based in California. In December 2006, Mazama also owned 2.1 million shares of Dendreon. It dumped more than a million of those shares sometime before or immediately after the March advisory panel meeting, when it seemed certain that Dendreon would receive FDA approval.

Only one other hedge fund dumped similar quantities of Dendreon shares at that time. It was JL Advisors, which is controlled by the above-mentioned Steve Cohen. This dumping of shares contributed to the selling volume that was amplified by whoever was selling massive amounts of phantom stock in Dendreon.

Then there was Renaissance Technologies, which held 800,000 shares in Cell Genesys when Milken’s “philanthropy” began promoting the company.  The CFO of Renaissance is James Rowen, who was previously the chief financial officer of SAC Capital, the hedge fund run by the above-mentioned Steve Cohen, who is known to be maniacal about making sure that his former employees remain satellites of his trading empire.

Meanwhile, hedge funds Balyasny Asset Management and Visium Capital held a combined 12 million shares of Cell Genesys. Balyasny and Visium have overlapping ownership (Dmitry Balyasny is a partner in both hedge funds) though they don’t generally disclose that in their SEC filings.

Dimitry Balysasny is a close associate of Steve Cohen. He has employed some of those former SAC Capital traders and managers with whom Cohen maniacally maintains relationships. And he and Cohen have attacked the same companies.

As I mentioned, Balyasny was one of our seven hedge fund managers with large numbers of put options in Dendreon. I will return to him, because this enigmatic Russian might have more surprises in store for Dendreon.

* * * * * * * *

Three weeks after Milken’s Prostate Cancer Foundation began publicly promoting Cell Genesys’s virtually untested prostate cancer treatment, Cell Genesys announced that it had signed a gargantuan $320 million deal to develop and commercialize GVAX with Takeda Pharmaceutical, the Japanese biotech giant.

The press reported this deal dutifully and uncritically, making it sound like GVAX was the next big thing. The stock price soared, earning large profits for the Milken-network hedge funds that had invested in Cell Genesys.

But just as there was something fishy about the Milken-invested Novacea and its $500 million deal with Schering Plough, so too did the “$320 million” Cell Genesys deal deserve a hearty dose of skepticism.

For starters, only days before Cell Genesys announced the Takeda deal, Takeda had bought a company called Millennium Pharmaceuticals. Millennium had been transformed into Takeda Pharmaceutical Capital Ventures. It was Takeda Capital Ventures, not the Takeda parent company, that signed the deal with Cell Genesys.  In other words, it was almost certain that Millennium’s management, most of whom had been retained by Takeda Capital, orchestrated the whopping $320 million deal.

That was rather strange because Millennium had been founded by a man named Mark Levin. It was Levin who orchestrated Millennium’s merger with LeukoSite, the biotech company that belonged to Marty Peretz, the Boesky-Milken crony who founded TheStreet.com. And more important to this particular episode,  it was Levin who had founded Cell Genesys. He founded the company basically by investing in himself (just as Domain Associates had created the Milken-invested Novacea out of thin air).

So, assuming Levin still had influence over Millennium/Takeda, and assuming he was still invested in Cell Genesys, he had just orchestrated a deal to use other people’s money to invest $300 million in himself.

Or, at least Cell Genesys’s press release said that Takeda (which was, in fact, Millennium) was going to “pay Cell Genesys an upfront payment of $50 million and additional milestone payments totaling up to $270 million…Takeda [actually Millennium, now known as Takeda Capital Ventures] will pay Cell Genesys tiered, double-digit royalties based on net sales of GVAX immunotherapy for prostate cancer…”

Sounds good, doesn’t it? Sounds like those “net sales” are imminent, right? In fact, just as the Milken-invested Novacea’s $500 million deal was dependent on clinical trials showing good results, so too was Cell Genesys’s big deal with itself dependent on the company producing some evidence that it’s drug actually worked. The operative phrase in that press release was “milestone payments totaling up to $270 million.”

Of course, just three months later, Cell Genesys announced that it had halted its trials of GVAX after its Independent Data Monitoring Committee, in a “routine safety review meeting,” observed “an imbalance of deaths…”  In other words, GVAX was not helping patients. It was killing them. And, of course, the $270 million worth of “milestone payments” announced with so much fanfare were unceremoniously canceled.

Either before this announcement, or immediately after, the big investors in Cell Genesys – Mazama, Balyasny, Millennium, Perceptive Advisors – all dumped their shares. Given the big boost those shares got from Milken’s Prostate Cancer Foundation promotions and the giddy announcement that Cell Genesys would receive $330 million, we can assume that those investors made a nice profit on their sales, just as Milken’s ProQuest and affiliated funds made nice profits on their sales of Novacea.

It seems to me that Cell Genesys, like Novacea, was a sophisticated pump and dump scam, aided by Michael Milken’s  “philanthropic” outfit, the Prostate Cancer Foundation.

Which brings us to Cougar Biotechnology, the third Dendreon “competitor” promoted by Milken’s Prostate Cancer Foundation.  Cougar Biotechnology, as we know, was controlled by Lindsay Rosenwald, who used to help run D.H. Blair, the Mafia-linked pump-and-dump shop whose two vice chairman pled guilty to securities crimes, and whose president was Milken’s former national sales manager.

D.H. Blair was indicted on 173 counts of securities fraud, and it was notorious for pumping and dumping biotech companies with no real medicine. But who knows? Maybe Cougar has a genuine product. It is hard to say at the moment, and will remain that way for years to come, because its prostate cancer treatment remains virtually untested.

In any case, just last month, Cougar, no doubt aided by the Prostate Cancer Foundation’s vigorous endorsements, wangled a $1 billion deal to merge with Johnson & Johnson, so Rosenwald and friends did quite well on their investments.

Remember that while Milken’s Prostate Cancer Foundation was using unwitting donors’ money to promote Novacea, Cougar Biotechnology, and Cell Genesys, its top officials, and perhaps Milken himself, were actively seeking to derail Dendreon, the one company that actually had a promising treatment for prostate cancer. This was certainly to the benefit of the short sellers (some of whom were illegally naked short selling) and the buyers of put options who were betting big against Dendreon

Meanwhile, it should be noted that Cougar Biotechnology experienced almost no naked short selling, according to SEC “failures to deliver” data. The Milken-invested Novacea also experienced virtually zero naked short selling, even after it announced that its treatment was killing people. The same goes for Cell Genesys — relatively little naked short selling, even when its treatment flopped.

The miscreant party line is that hedge funds do not engage in naked short selling to manufacture phantom stock. The party line is that most “failures to deliver” are the result of mechanical “errors.” It’s funny how those “errors” tend to occur when miscreants in a certain network are short a company. It’s also funny that those “errors” don’t happen to companies in which Milken and his cronies are invested.

If only there were a pattern.

* * * * * * * *

To be continued…Click here for Chapter 14.

What follows is PART 10 of a 15-PART series. The remaining installments will appear on Deep Capture in the coming days, after which point the story will be published in its entirety.

Click here to read PART 1

Click here to read PART 2

Click here to read PART 3

Click here to read PART 4

Click here to read PART 5

Click here to read PART 6

Click here to read PART 7

Click here to read PART 8

Click here to read Part 9

Where we left off, we had learned that on March 29, 2007, an FDA advisory panel had voted overwhelmingly that Dendreon’s promising treatment for prostate cancer should be approved. As a result, most financial analysts and investors were expecting that Dendreon would become a profitable company. However, ten hedge funds (out of a universe of 11,500 hedge funds) held large numbers of Dendreon put options (bets against the company), suggesting they had reason to believe that Dendreon would be derailed. At least seven of those hedge funds can be tied to Michael Milken or his close associates.

We had also learned that Michael Milken himself stood to profit if Dendreon were to experience any unexpected problems receiving FDA approval. This is because Milken was the early financier and principal deal maker for ProQuest Investments, a fund that (along with an affiliate) controlled a company called Novacea, which was one of Dendreon’s competitors in the race to produce a new treatment for prostate cancer. Meanwhile, a Milken crony, Lindsay Rosenwald (who once helped run D.H. Blair, a Mafia-linked brokerage which specialized in pumping and dumping fake biotech companies) controlled Cougar Biotechnology, which was Dendreon’s second competitor in the race to develop a treatment for prostate cancer. In addition, we had learned that Milken’s “philanthropic” outfit, the Prostate Cancer Foundation, had supported Novacea and Cougar, while turning its back on Dendreon.

Finally, we had learned that on April 13, 2007, The Cancer Letter, a newsletter with a record of publishing information leaked from the FDA in the service of select Wall Street hedge funds, published another FDA leak. This leak was a letter written to the FDA from a doctor named Howard Scher, who was a board member and executive of ProQuest Investments and the chairman of the “Therapeutic Consortium” of Milken’s Prostate Cancer Foundation. In that letter (an unprecedented attempt to lobby the FDA after an advisory panel had already voted), Dr. Scher argued vehemently that Dendreon’s treatment should not be approved.

One of Dr. Scher’s principal arguments against Dendreon was that the FDA advisory panel had improperly “changed the question” regarding the efficacy of Dendreon’s treatment. As we saw in Chapter 9, that claim was false, and Dr. Scher’s other arguments were specious.

But Dendreon’s enemies continued to whisper in reporters’ ears about this issue of “the question,” and the unprecedented lobbying of the FDA continued.

Now we meet another conflicted doctor and the sixth of those seven hedge funds that bet big against Dendreon right before the lobbying began….

* * * * * * * *

On April 20, three weeks after the advisory panel vote, and one week after Dr. Scher’s missive appeared in The Cancer Letter, Forbes journalist Matthew Herper published a story arguing that there was a good chance the FDA would not approve Dendreon’s cancer treatment outright. “If the agency wants to ask Dendreon for more data, it certainly has some outs,” Herper wrote. “The FDA changed the wording of the question…”

Three days later, Dr. Maha Hussain, one of the panel doctors who had quickly voted “No” on the bogus question, wrote a letter to the FDA arguing that Dendreon’s treatment should not be approved. This letter, like Dr. Scher’s, was addressed to FDA commissioners and was presumably confidential. And this letter, like Dr. Sher’s, found its way to The Cancer Letter, which posted it for all to see just three days after it was written.

Dr. Hussain’s arguments were precisely the same as those employed by Dr. Scher and the whispering folks on Wall Street. “The recommendations for approval…are based on data that can only be characterized as best as ‘suggestive’ of possible benefit,” she wrote. “From the scientific and procedural aspects, in general, it would seem that at the end of the day what should determine a positive verdict in any therapeutic trial is the strength of the evidence as critically reviewed by an Advisory Committee…with clear guidance on the question posed to the committee within the framework of the regulatory guidelines and requirements of the FDA for approval.” [Italics mine]

That is, Dr. Hussain—like Dr. Scher, the singing Sendek, and whoever was feeding the journalist Matthew Herper–was suggesting that the FDA panel had voted on the “wrong question.”

Meanwhile, Jonathan Aschoff, the physician-impersonating financial analyst who’d set a target for Dendreon’s stock price to reach a mere $1.50, was telling journalists that the FDA panel would not have voted to approve Dendreon’s treatment if it weren’t for the “substantial” rewording of “the question.” On April 25, Aschoff issued another damaging report, this one asserting, once again, that the FDA would ignore its panel because the panel had voted on the “wrong  question.”

By this time Dendreon supporters were busily circulating transcripts showing that the FDA panelists had, in fact, voted on the legal question. The supporters had also discovered Dr. Scher’s ties to Novacea, Cougar Biotechnology, Proquest, and Michael Milken, and began explaining to all and sundry that ProQuest and Novacea would cash in if Dendreon were not approved. Moreover, the supporters had revealed that Dr. Hussain, the second letter writer, had also done work for the Milken-invested Novacea, and was a member of the “Therapeutic Consortium” of Milken’s Prostate Cancer Foundation.

On April 26, Matthew Herper of Forbes published another article – this one repeating the arguments in Dr. Hussain’s letter. Herper, who had been told about Scher’s conflicts of interest, had apparently decided to investigate. This investigation seemed to have involved nothing more than asking Dr. Scher if he had any conflicts of interest. In his April 26 article, Herper  reported that Scher’s spokesman said “that Scher had nothing to do with his letter leaking [and appearing in The Cancer Letter], and that he knew of no family members who would benefit financially either way if Provenge were approved.”

To reinforce Scher’s credibility, and to make Dendreon’s supporters look silly, Herper added that the supporters had alleged that “Scher’s wife works for a hedge fund that might be short Dendreon…This is not true. She works in human resources for a nursing home company that could not conceivably benefit materially from any news about Dendreon.”

Aside from ignoring Scher’s ties to Milken’s ProQuest Investments, which would profit handsomely if Dendreon were not approved, Herper misconstrued the information about Scher’s wife. The truth was, Dendreon’s supporters had revealed that Scher’s wife had a cousin, Barry Lafer, who was a hedge fund manager. Phone records legally obtained by Deep Capture show that Scher called Lafer, at his office, on April 23, while Herper’s article was in the works.

But the main point of Herper’s article was that “all this debate” (i.e. the Wall Street whispering and the conjectures of two conflicted doctors) made “Dendreon an even riskier stock than other biotechs.” Herper added that according to unnamed “others,” Dendreon’s “studies do not rise to the level usually required for approval.”

Besides being false, this was another way of suggesting that the FDA panelists, all experts in their field, voted in favor of Dendreon because they had misunderstood the standards for approval. They had been asked the “wrong question.”

On April 29, Bloomberg News reported that Dendreon’s shares were being sold at “a record pace” as investors “bet the company’s experimental prostate-cancer drug will fail to win approval from U.S. regulators.”

Then, on May 4, there was yet another letter.  This one was from a University of Washington biostatistician named Dr. Thomas Fleming. It is perhaps noteworthy that Fleming had done work for Gerson Lehrman, an outfit that is owned by former hedge fund managers.

Gerson Lehrman has a remarkable business model which can best be described as “institutionalized bribery.” Clients, mostly hedge funds, hire Gerson to put doctors and other experts on the payroll. In exchange for the payments, the doctors agree to provide hedge funds with “insight” (some say they provide inside information) about clinical trials of drugs that are marketed by public companies. The doctors also agree to talk to reporters (and perhaps also to the FDA) about these drugs. In at least one case it has been clearly established that these hired sources lied (which could well explain, of course, why they were hired).

Like the letters from Dr. Scher and Dr. Hussain, within days of its creation Dr. Fleming’s missive miraculously ended up in the hands of The Cancer Letter, which eagerly published it.

“Reportedly Scher felt motivated to write the letter after being kept awake the night following the [advisory panel],” wrote Dr. Fleming. “I also was kept awake the night following the panel.”

In addition to knowing about Dr. Scher’s sleeping habits, Dr. Fleming shared Dr. Scher’s concern that approving Dendron’s treatment might derail Asentar, the drug that was being developed by Milken’s Novacea. How “could one defend internal consistency at FDA if [Provenge] were to be approved before the [Asentar] trial?” Fleming asked.

By this time, Dendreon’s supporters (a rambunctious bunch) were screaming and howling about the dishonesty of those who had suggested that the advisory panel had been asked the “wrong question.” So the party line changed a bit. Now it was that the panelists who had voted in Dendreon’s favor must have been somehow confused. Dendreon trials did not “provide ‘substantial evidence of efficacy’, Dr. Fleming wrote. “Rather at best, these trials provide plausibility of efficacy…”

I’ll leave it to the reader to parse the difference between “plausibility” and “substantial evidence.” But clearly, this letter was yet another strange occurrence.

Four days later – May 8, 2007 — the FDA told Dendreon that it was rejecting the company’s application for Provenge, a paradigm-shattering vaccine for those terminally ill with prostate cancer.

* * * * * * * *

The SEC’s partial data shows that more than 12 million Dendreon shares “failed to deliver” on May 10, 2007.  Traders are given three days to produce stock before their trades are registered as “failures to deliver,” so it is clear that hedge funds had sold the 12 million shares of phantom stock on May 7 — the day before the FDA made its decision. This suggests that somebody was aware of this imminent decision. We don’t know who engaged in that naked short selling because, as far as the SEC is concerned, it’s a big secret.

But we do know that a mere 10 hedge funds held large numbers of put options (a bet that the stock price would fall) as of March 31, a few days after the advisory panel’s nearly unanimous vote in Dendreon’s favor. Obviously, these were hedge funds with remarkable foresight concerning a long-shot event (the FDA’s decision to go against the overwhelming recommendation of its advisory panel to approve a drug for terminally ill cancer patients). Seven of those hedge funds belong to a mischievous Wall Street network that is known for its foresight – and for attacking companies that, coincidentally, are victims of illegal naked short selling.

Five of these hedge funds I have already named. All have ties to Michael Milken or his close associates. Some have ties to the Mafia. They are: Bernard L. Madoff Investment Securities, Perceptive Advisors, Millennium Capital, Steve Cohen’s Sigma Capital, and Pequot Capital.

In preparation for naming the sixth, we need to hearken back to September 2001, when two airplanes crashed into the twin towers of the World Trade Center, one crashed into the Pentagon, and a fourth dove into a field in Pennsylvania. On the day before that attack, a short seller named Anthony Elgindy called his broker and ordered him to liquidate one of his accounts, giving the explanation that a big event was about to occur. Mr. Elgindy said that on the following day (that is, on September 11, 2001) the market was going to  lose two-thirds of its value.

After the 9-11 attacks, that broker notified the FBI of Elgindy’s eerie prediction, and the FBI launched an investigation. In the course of this investigation, the government learned  that Elgindy had sold massive amounts of phantom stock, and that he routinely blackmailed and threatened companies that he was selling short. The government also learned that Elgindy had ties to terrorist outfits in the Middle East, and for a time prosecutors argued in court that Elgindy had advance knowledge of the 9-11 disaster.

Ultimately, though, Elgindy was convicted and sentenced to 11 years in prison for the more demonstrable crimes of stock manipulation and paying bribes to two FBI officials who fed him information from the FBI’s National Crime Information System (one of those FBI agents actually kept Elgindy informed of the progress of the investigation into Elgindy’s connection to the 9-11 attacks). In June, 2009, it was learned that the SEC’s inspector general had begun investigating SEC officials who are also alleged to have collaborated with Elgindy, either by providing inside information on commission investigations, or launching destructive, dead-end investigations of companies that Elgindy was selling short.

Elgindy, like Bernard Madoff  (the Dendreon short and Ponzi schemer who helped write the SEC’s rules on naked short selling), is believed to have ties to organized crime. He once worked for a now-defunct Mafia-connected brokerage called Blinder Robinson (known on the Street as Blind’em, Rob-em), and a source close to the Elgindy investigation has told Deep Capture that, shortly before Elgindy appeared for sentencing, Russian mobsters forced Elgindy to saw off the tip of one of his own fingers as a reminder not to squeal on other members of his network.

There is evidence – including transcripts of Elgindy’s private Internet message board – that shows that Elgindy routinely attacked public companies in collaboration with certain hedge fund managers. A significant number of these hedge fund managers were part of the Milken network.

One of them was Jeffery Thorp, whose father once worked with the Genovese organized crime family to develop a method for cheating Las Vegas casinos. The government’s investigation of Elgindy eventually led to Thorp, who was charged in 2006 with providing fraudulent “death spiral” PIPEs financing to 22 companies. The SEC’s case, one of the rare instances in which the commission has identified a naked short seller by name, makes it clear that Thorp sold massive amounts of phantom stock, ultimately destroying the 22 companies that had received his fraudulent PIPEs.

Recall that similar “death spiral” PIPEs were arranged by Carl Icahn’s Ladenburg Thalmann, ending in the phantom stock ruination of more than 20 companies. Icahn is the “prominent” investor who owes his status as a billionaire to Michael Milken and the Mafia-connected Zev Wolfson. Icahn is also the “prominent” investor who, along with Ziff Brothers and Steve Cohen, called ImClone immediately before The Cancer Letter published the “leaked” news of an FDA decision.  Icahn is also the “prominent” investor whose former employee was the last man to see Alain Chalem (a Mafia-connected naked short seller) before Chalem’s head was riddled with bullets by Russian mobsters.

Do you still not believe that this network has ties to the Mob? Consider that Thorp’s father, in addition to working for the Genovese organized crime family, was the single most important player in the stock manipulation network that Milken operated in the 1980s.

The father, Edward Thorp, ran a hedge fund called Princeton-Newport. The FBI eventually raided that operation, hauling away phone recordings and documents. Thorp was not ultimately charged, but the evidence that the FBI retrieved that day featured prominently in the prosecution’s 98-count indictment of Milken. Indeed, people who worked on the case say that the Princeton Newport evidence was far more important to the prosecution than the testimony of Milken’s more famous co-conspirator, Ivan Boesky.

Do you still not believe that people in this network employ precisely the same ruthless tactics? Consider that when the FBI investigated Elgindy, it also stumbled upon a hedge fund called Gryphon Partners. One of Gryphon’s portfolio managers, Jonathan Daws, was eventually charged with participating in various short selling schemes hatched by Elgindy and his bribed FBI agent. In pleading guilty, Daws said, “others at Gryphon made trades in some of the relevant stocks, independent of me, and not at my direction.” Daws was convicted.  No charges were immediately filed against Gryphon.

However, in 2006, the SEC sued Gryphon for providing fraudulent “death spiral” PIPEs financing to 35 companies. Like Thorp and the hedge funds introduced by Carl Icahn’s Ladenburg Thalmann, Gryphon provided its PIPEs financing knowing that it would cause stock prices to fall. The hedge fund then hammered the companies with naked short selling, sending their stocks into “death spirals.” Most of the 35 companies were destroyed.

So, at this point in the story, we have identified more than 70 companies that have been vaporized by “prominent” investors, all part of the same network.

At any rate, Gryphon Partners, the Elgindy-connected, PIPEs-financing, 35 company-destroying SEC-sued death spiral finance house, was founded by G. Stacy Smith and Reid S. Walker, two “prominent” investors who have since gone on to greater things. They now run a hedge fund called WS Ventures.

And WS Ventures is the sixth of our seven “colorful” hedge funds that had the foresight to own large numbers of put options in Dendreon at the end of March 2007, just after the seemingly fantastic news that the advisory panel had voted overwhelmingly in Dendreon’s favor, and during the period when Dendreon was awash in illegal naked short sales, and just before the disastrous news that the FDA had rejected the advice of its own advisory panel.

A few months later, Dendreon, on the verge of collapse and desperate for money to support its sabotaged prostate cancer treatment, went ahead and signed a deal to receive its first “death spiral” PIPEs finance.

* * * * * * * *

To be continued….Click here for Chapter 11.

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