One of the arguments made with metronomic regularity by those defending stock manipulation, and unthinkingly regurgitated by their lapdog financial reporters, is this: Demonstrate the harm caused by naked short selling (the fact of its illegality being too conceptually difficult for them to grok). Well, here is a good example.

Dendreon (DNDN) is “a biotechnology company, engages in the discovery, development, and commercialization of therapeutics to enhance cancer treatment options for patients. The company’s product portfolio includes active cellular immunotherapy, monoclonal antibody, and small molecule product candidates to treat various cancers.” For the last few years its operations have burned through $66 million to $80 million per year (a not-unusual pattern for pharmaceutical firms researching and developing cures for diseases like cancer).  As it stands, its balance sheet looks like it could support perhaps one more such year without additional capital raising. However, given the $5 share price at which Dendreon has been hovering, such additional capital raising would dilute the owners about 20%, assuming that it is possible in the current environment.

It turns out that the collapse of DNDN from over $20 to that $5 price was accompanied by massive levels of naked shorting. At one point, 18 million shares were unsettled (about 20% of the ownership of the company). It cannot be repeated too often: That is just the data coming from one crack in the system, the CNS bucket at the DTCC, and does not include any fails accumulating at the brokerages, or diverted by pre-netting, or masked by the Stock Borrow Program, or swept into the ex-clearing system, or stemming from offshore failures. So it is the tip of the iceberg (and perhaps, the tip of the tip of the iceberg).

As is so often the case, manipulations in Dendreon stock coincided with all that we have come to expect: surprise rejection of its drug Provenge by the FDA, endless bashing from the likes of the Media Mob and Jim Cramer the Self-Confessed Crook, and other strange incidents soon to be explored by my Deep Capture colleague, journalist Mark Mitchell.

Click image to enlarge

Of late, this story has taken a happy turn. On April 14 Dendreon released prelimary results of their prostate cancer vaccine trials (details of which will be disclosed at this coming week’s American Urological Association’s (AUA) Annual Meeting in Chicago) showing that Provenge works. It prolongs the lives of men with advanced stage prostate cancer.  Its stock promptly quadrupled, which will make getting financing easy (Investors Business Daily, “Prostate Cancer Drugs Get Street’s Attention“).

I will assume that most readers agree that it is a good thing that Dendreon managed to survive long enough to see this day, and that it would have been a bad thing if illegal stock manipulation had suppressed Dendreon’s stock until they ran out of cash and could raise no more (as they say in intro logic classes: “If not, work the proof out on your own”). Which makes this serve, of course, as answer to the challenge that opened this essay.

Given that, one may then ask of those journalists who defend the right of hedge funds to destroy firms they wish to destroy, that is to say, of DowJones’ Carol Remond and Karen Richardson, of Fortune Magazine’s Roddy Boyd and Bethany McLean (now at Vanity Fair), of New York Times’ Floyd Norris and Joe Nocera, of Herb Greenberg hiding behind vapid emails and Dave Kansas hiding under his desk, of NY Post/Portfolio Magazine’s Dan “Crusher” Colarusso and CNBC’s Jim Cramer the Crook: Do you get it now? Do you understand why illegal stock manipulation is wrong, and can impose costs on society it was your duty as journalists to explore? You purveyors of reportorial Velveeta, you lazy and captured, half-educated and dim-witted, snarky, insufferable, conformist and indolent pseudo-intellectual lickspittles, do you get it now? You are sell-out journalists who grovelled to your sources, missed the story of your careers, and in the eyes of an increasing fraction of the public, rank just below pedophile priests.

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(Click graph to enlarge)

On September 18, 2008, the SEC announced an emergency ban on short-selling. 797 tickers belonging to companies in the financial industry could not be shorted for the next three weeks. This was a drastic if temporary move, cutting off short activity cold-turkey to save the patient. Or, so it seemed at the time.

The rule went into effect the next day. Companies were added and dropped, exceptions were made — and then, exceptions to those exceptions — but the overall impression left with the investing public was one of a total ban, a wall of protection around the banned stocks.

SEC Chairman Cox commented recently that, “the actual effects of this temporary action will not be fully understood for many more months, if not years”. We here at Deep Capture just could not wait that long. So we looked at actual short sales effected on NYSE ARCA for the tickers in question, for the duration of the ban. The picture that emerged was less that of a total ban and more of a… well, let’s allow the numbers to speak for themselves.

We chose NYSE ARCA (Archipelago) for this experiment because it makes short sale data available. While it would be easy for all exchanges to release data on short sales, only two do so. This practice started as part of a pilot program to measure the effects of REG SHO and at one time, every exchange participated. By August 2007, the SEC had stopped requiring the release of short sale data because it was too burdensome for the exchanges. The two that went on publishing (Archipelago and Philadelphia), we might assume, forgot to turn off the database scripts that automatically generate these reports.

So what does the data say? To keep things simple at the outset, we only considered the original 797 tickers on the ban list. There were 940,000,000 shares worth of short sales executed on Archipelago for that subset of banned tickers. These 797 tickers were 80% of the 976 that eventually ended up on the list. Furthermore, only 705 (under 90%) had short trades executed on Archipelago. And for those tickers, Archipelago executed only 19% of the overall volume during the dates in question. Thus, to back into an estimate of the total shorting that took place in these tickers while there existed a ban against shorting them, one would calculate that 940,000,000 is 19% of 90% of 80% of all the shorting: this would imply that over 7 billion shares were shorted in these companies, while they enjoyed a ban against shorting their stock.

To be fair, a few tickers ended up being dropped from the list (and could be expected to exhibit regular shorting activity for part of the ban period). Excluding all trades in those tickers during the ban period (a generous assumption) would mean subtracting 1.4 million in volume. 938 million and change is the most conservative number that results from this calculation.

One question that naturally arises is this: what level of short sale activity should be considered normal on Archipelago? During the same period a year ago (a period that included the same number of trading days), these very same stocks racked up 332 million in total short volume on Archipelago. Granted, Sep/Oct 2008 was no ordinary time for market volume. Yet an almost threefold increase over the same period last year, coming at a time when there was ostensibly a total ban on shorting these stocks strains credulity. Below is a chart comparing the short sale volume for the same dates in 2007 and 2008:

Coverage of the ban in financial media has been almost uniform in emphasizing the ineffectiveness of the ban. Jubin Zelveh titles his Portfolio.com blog entry on Dec. 19, “S.E.C. Short-Sale Ban: Pretty Much Useless” and quotes from a new academic paper in the pipeline showing a steep drop in the prices of banned NYSE-listed stocks. William Ackman of Pershing Capital (a person-of-interest here at Deep Capture), quoted in a Reuters piece on Oct. 6, proclaims, “Short sellers have been blamed for bringing down the market, but since the ban, the markets have been falling even further, which means ‘the longs’ are selling now.” Menachem Brenner and Marti G. Subrahmanyam, in their commentary on Forbes.com from October 1st titled, “End The Ban On Short-Selling” speculate that the ban on short sales, “may have already contributed to a further decline in prices”.

The take-away from the coverage is that there was ostensibly a total ban on short selling and prices declined anyway – suggesting that short sales were not to blame for falling prices, after all. A stretch, even if one concedes the underlying assumption but a somewhat plausible argument. What it fails to consider is how imperfect a ban this turned out to be.

And finally, Chairman Cox himself declared just the other day, “The costs appear to outweigh the benefits” — professing regret over the short-selling ban. What costs/benefits went into that analysis, we do not yet know. What we do know is that the ban on short selling was far from total in practice. A barrier marked with 940 million holes is, in fact, a sieve… and any analysis that laments its meager virtues should recognize that fact.

This series will analyze the many ways in which the short-sale ban has indeed been a sieve.

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Bidz.com is an online auction company which went public in May of 2007. Take a look at the company’s relatively short price history, to see if you can spot the abrupt 49% drop.

(If you chose November 23-28, 2007 you win the Deep Capture home game!)

To better understand what was going on during those four trading days, let’s zoom in to look at just Bidz.com’s first seven months, and include each day’s failed trades.

As any regular readers of this blog might have predicted, that 49% drop was accompanied by a similarly anomalous jump in BIDZ settlement failures to deliver (FTDs).

Indeed, during its first 136 days of trading, BIDZ, with a float of under 12-million shares, experienced about 1.5-million FTDs, an average of about 11,000 per day.

Then, in the nine trading days between November 12-23, 2007, nearly 7.2-million shares — averaging nearly 800,000 per day — failed to settle, resulting in a tremendous, artificial swelling of supply of BIDZ shares.

To better understand what happened next, let’s take a closer look at that spike in fails and drop in price, in relation to a particular external event.

November 26, 2007 (highlighted in yellow) marks the date of publication of an attack on BIDZ by short selling blogger Andrew Left of Citron Research (formerly known as “Stock Lemon”). The report made a few subjective observations relating to BIDZ’s inventory levels, as well as revealing the criminal record of one of the company’s vendors: neither of which were good news, but hardly bad enough to justify cutting its share price in half.

This episode is instructive on two levels.

First, it offers insights into how the criminals engaged in the kind of manipulative short selling observed here use other — often engineered — events as “cover” for their activities.

Second, it provides conclusive proof that either Andrew Left’s Citron Reports is a tool of these illegal naked short selling hedge funds, or those hedge funds have clairvoyants on staff.

Given how poorly things have gone for these folks now that illegal naked short selling has grown increasingly difficult to engage in, I’m leaning toward the former.

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As is explained in numerous pieces in DeepCapture, there are many cracks in the settlement system, one of them being the DTCC’s Continuous Net Settlement system, or CNS. I am highly confident that the federales (at least, the SEC) are not permitted to explore the other cracks, that the failures to deliver that they see within the CNS are thus but a small fraction of all that exist, and that, therefore, trying to gauge the depth of the naked short selling problem from the level of FTD’s in the CNS is like trying to guess the condition of an automobile from the level of water in its radiator.

But it’s a start. Given that the CNS system is the one place the SEC can look, and might be able to do something about, it is instructive to see how well they are cleaning up unsettled trades there.  Towards that end, DeepCapture has analyzed the data that the SEC released last week. These graphs show their fine progress in that regard.

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Any questions?

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This story gets told in pictures, mostly.

Take a Mercedes, stir in a couple hundred thousand dollars, and you get a car called a Maybach. Hedge fund guys in New York and Connecticut buy them.

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This is a Humvee. US military personnel drive them around war zones.

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This is an Improvised Explosive Device. Extremists set them up on roadsides in Iraq and Afghanistan.

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When a Humvee meets and IED, this is the result:

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Fortunately, there is a company in South Carolina called “Force Protection, Inc.” They manufacture “Mine Resistant Ambush Protected” vehicles (“MRAP”).

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Under their skin, MRAPs have V-shaped hulls that deflect bomb blasts, making them nearly impervious to IED’s. The last time I checked (June, 2008), there had been 300 IED attacks in Iraq against MRAP’s, and only one death (that, when the explosion caused a roll-over which killed the soldier in the gun turret).

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The Department of Defense has placed huge orders for MRAP’s. Force Protection revenue has soared, and they are nicely profitable.

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The stock price of Force Protection was holding its own….

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A natural move at this point might have been to do a secondary, that is, to sell some more of their stock into the public market, raising capital with which they could expand their production to keep up with DOD demand.  However, someone started naked short selling them:

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Force Protection is thus not able to complete a secondary, and remains unable to meet DOD’s demand.

Thus, this month more of these will be sent home from Iraq……..

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….. so that soft hedge fund guys can have more of these:

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2) go here for additional suggestions: “So You Say You Want a Revolution?“

In a previous post I named various places where unsettled trades can accumulate: in the desks of brokers, in pre-netting among brokers, in the Continuous Net Settlement (CNS) system, in the Stock Borrow Program (SBP), through ex-clearing, and in delivery mechanisms from offshore exchanges. For all I know, these represent just a subset of the cracks in the system. The great unanswered question is, How much financial toxic waste has naked short selling and its various equivalents left scattered throughout these cracks?

The answer is: I don’t know, and I think no one knows. I suspect no one agent has the full picture of what is going on across all of these cracks. In fact, I suspect some of these cracks are so obscure no one has a clear picture of what is going on in them individually, let alone collectively.

To some degree this is knowable a priori. We have a system that is shielded from scrutiny of every type. State regulators cannot successfully subpoena it (as various state regulators have told me) because the DTCC argues it is shielded by federal regulation. Yet when Feds try to look inside it they are simply rebuffed, and are helpless to assert themselves (as a high-level SEC official told some colleagues of mine). The Feds do not understand it (as a former DTCC employee and various Feds have told me). On those occasions that the Feds do get to look inside the system,  they get shined-on (as a former DTCC official tells me and a former SEC official confirms).  In fact, four years ago when I began this quest, the first thing I tried to do was to find out who regulated the DTCC, and quickly discovered that, other than a brief mention in an obscure GAO report, even the Feds are not sure if they regulate it.  And yet, through this opaque system the treasure of the ages passes every week. Such system-design is a recipe for disaster.

To a lesser degree this is knowable a posteriori, though getting data about the system from the system is an exercise in Kafkaesque futility. There are endless anecdotes of trades that won’t settle, of course. There is also the partial information expressed by the Reg SHO list.  There are various FOIA responses which have been pried from the SEC. And for the true aficionados, there are, lately, data files that the SEC periodically releases to the public regarding failures in one of the cracks mentioned, the CNS. Making use of these files is impractical for any members of the general public who do not employ an economist, statistician, and database expert to work the data.

Fortunately, DeepCapture employs an economist, a statistician, and a database expert to work the data. In the following series of posts I am going to reveal their output, stressing again that the failures I will be disclosing are not the totality of failures, but simply a fraction of the total, residing in just one of the cracks (the CNS) into which our federal regulator is permitted to peer.

Here is a chart showing the CNS failures from 2004, the year Reg SHO was adopted, through Q1, 2008:

Here is the same data with some key Reg SHO dates noted:

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I suppose I should write something brimming with wit and brio about the chart above, but since 500 people lost their jobs today as VeraSun declared bankrupcy, I think I’ll skip that and just state the point like the crescendo of a dry old economics class:

A price is a combination of of information about value and scarcity, and because some folks likely manipulated the scarcity in VeraSun, they likely manipulated the price. Thus VeraSun was likely deprived the ability to access the capital markets at the true market-clearing price for any securities offering for at least the last year, and maybe for longer. Say what some will about its business model, its adventures in corn futures, the virtues of corn-derived ethanol (not a big fan myself), etc., the point is that those capital allocation decisions are something the market should figure out, not “something the market should figure out but one side gets to sell and fail to deliver over and over and over.”

Interestingly, we don’t even know what happened with the fails during the third quarter because, as the SEC explains right now, tonight, on their website, in this choice little nugget:

“V.1.11. Can I obtain fails information?

“Currently, threshold lists include the name and ticker symbol of securities that meet the threshold level on a particular settlement date. Some investors have requested that the SROs provide more detailed information for each threshold security, including the total number of fails, the total short interest position, the name of the broker-dealer firm responsible for the fails, and the names of the customers of responsible brokers and dealers responsible for the short sales. The fails statistics of individual firms and customers is proprietary information and may reflect firms’ trading strategies. The release of this information could be used to engage in unlawful upward manipulation of the price of the securities in order to “squeeze” the firms improperly. “

In mid-2004 the Securities & Exchange Commission (itself a kind of a joint venture of the US federal government and Wall Street) adopted Regulation SHO. Among other things, “Reg SHO” insisted that exchanges publish the names of firms being victimized by naked short selling. They left plenty of loopholes (grandfathering, offshore failures, option market making abuse) and used lots of weasel-words to say it, and courteously stipulated no penalties for failing to follow the rules, and gave everybody until January 2005 to figure out new ways around them, but tepid though these measures were, curtailing naked short selling was their basic thrust.

This graph registers the daily total of companies appearing on the Reg SHO list.

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I have maintained all along that naked short selling was not a hard problem to solve: it was just a hard problem to solve without seeing about 20 rich guys get their asses handed to them. And because they were rich and well-connected, efforts to persuade the federal government to enforce the law were stopped dead in their tracks.

Somewhere in the middle of 2008, after the horses bolted from the barn, the barn collapsed, the barn burned, and the barn’s ashes scattered to the four winds, the federal government decided to close the barn door. They enacted a subset of the reforms which Deep Capture and a handful of other activists had been suggesting for a few years. The data suggests those reforms are working. I would not stake money on the likelihood that this means much, but hope springs eternal….