Jan 14 • 12M

Chapter 10, Part 2: Short Seller

Before he got infamous for drug pricing, Martin Shkreli made a name for himself as an irksome short-seller. But what was so bad about that?

 
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My experiences uncovering the story of, and falling in love with, Martin Shkreli.
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A young, and even younger-looking, short seller Martin Shkreli.
A young, and even younger-looking, short seller Martin Shkreli.

Let’s be clear from the start here: I do not have any deep knowledge of biotechnology. Like most Americans, I find the sector both awe-inspiring and virtually incomprehensible. Names of cutting edge drug candidates all look to me like they came out of a vaguely scientific random syllable generator. You end up with a ton of words like “bezalabub,” “anthrixistide,” “aducanumab,” or “sparsentan.” (Two of those words are made up, two of them are real.)

It doesn’t take very long, when looking at a string of names like that and the dense language around them, for a normal person to mentally tap out and stop paying attention. Yet as laughably impenetrable as biotech is, it is a magnet for very serious money…for good reason. Biotech promises lucrative miracles, like restoring sight to the blind, preventing cancer, and curing hepatitis C

The shroud of complexity in the sector also conceals snake oil salesmen, shady practices, bad management, and shaky ideas. How does an ordinary investor tell the difference? Well, they can consult market analysts and read business media — although both have major limitations. Analysis that’s widely available to the general public is mostly of the Jim Cramer/“Mad Money” variety. And most mainstream business journalism is more of an agent of hype rather than a dismantler of it, at least until something big goes wrong. 

Luckily, markets have their own predatory species which help prune the herd. Driven by an appetite for profit, they sort out the weak links and the naked emperors from the genuinely good investments, and attack them mercilessly. As brutal and greedy as they may seem, these predators keep the business ecosystem in order. I’m of course talking about short sellers. And Martin Shkreli styled himself as a particularly voracious one.

Short sellers are usually portrayed more like despicable parasites or vultures in the media, which has always seemed odd to me. The successful short sellers are often highly-intelligent contrarians who are constantly testing assumptions and conventional wisdom, and digging under the hood of whatever assets they are looking at. In that sense, they’re very much like investigative reporters. The only difference is they stand to directly reap financial gains if they are right. Journalists are typically not allowed to have a financial stake in anything they report on.

There are a couple instances of short selling being cast as “heroic,” though. One was in Michael Lewis’s “The Big Short,” a well-known book and and an even more well-known movie, which lionized short seller Michael Burry for making a killing by betting against the subprime mortgage market in the lead up to the 2008 real estate crash. 

The other is my favorite Christmas movie, the 1983 comedy “Trading Places.” At the end of the movie, co-stars Dan Aykroyd and Eddie Murphy get vengeance on greedy sociopaths the Dukes, and make themselves rich in the process, by short-selling frozen concentrated orange juice futures.

The scene from “Trading Places” where the two heroes get rich by shorting commodities futures.
The scene from “Trading Places” where the two heroes get rich by shorting commodities futures.

But those are definitely exceptions. The mainstream view of short sellers, to the extent there is one, usually resembles the way the Citizens for Responsibility and Ethics in Washington described them in a March 2015 letter to Congress: as manipulators looking to use whatever tool they can, including government investigations and public opinion, to drive down stock prices for their own gain.

The organization singled out three short-sellers over allegedly dodgy tactics. Those included billionaire hedge fund manager Bill Ackman, who had a massive short position in Herbalife, a multilevel marketing company that peddles nutrition supplements, teas and shakes; Steven Eisman, an investor who bet against the for-profit college industry (and who was also featured in “The Big Short” for anti-mortgage trades); and of course Martin Shkreli, who regularly shorted biotech companies.

The problem, CREW claimed, was that Ackman, Eisman, and Martin were all trying to alert government officials and the media to alleged problems in the companies they were shorting. The investors were “injecting themselves directly into government processes – sometimes openly and sometimes stealthily – in the hope of manipulating the outcome to their financial advantage,” fretted the organization in its letter. 

“Americans already believe both Wall Street and Washington are rigged to the benefit of the rich and powerful,” the organization wrote. “We urge you to investigate the conduct of Mr. Ackman and others and consider how to deter investors more broadly from abusing government processes.”

Martin wrote posts about biotechs he was shorting for the blog Seeking Alpha and drafted citizen petitions to the FDA about the companies. And Ackman lobbied government agencies to crack down on Herbalife along with frequently telling the press that he believed the company was a pyramid scheme that preyed on the poor. Eisman engaged in similar actions.

None concealed their financial interests from the public. For instance, everyone knew that Ackman was shorting Herbalife, and Martin always conscientiously made note of his investments in his blog posts and petitions.

If you can’t tell already, I am skeptical of the watchdog organization’s concerns and characterizations here. Short sellers who make their financial interests known while also providing their intel to the press and government investigators aren’t “rigging” anything. They’re like any other source with an agenda for sharing information. In fact, they’re probably being more transparent than most sources with agendas.

And let’s be straight here: Almost every source providing information to a journalist or the government has an agenda.

Interestingly, members of Congress on the other hand, have lots of opportunities to rig markets for any number constituencies based on whatever they are lobbying for, voting for or investigating. They also aren’t prohibited from trading stocks while in office, creating massive potential for insider trading. A 2012 law attempted to address those conflicts by mandating more disclosures, but the penalties for noncompliance are small and lawmakers still fail to follow it properly.

Not to mention, I find it hard to see Herbalife — which does look very much like a pyramid scheme — for-profit colleges, and whatever biotechs Martin was lambasting to be “victims” of dastardly deeds. Each is more than fair game for criticism, including financially motivated criticism. 

Screenshot of a story about Ackman’s campaign against Herbalife.

Most significantly to me, attacking a company’s stock price through (good faith) public criticism and instigating government actions won’t even work unless the short seller has credibility and is raising a valid point. That’s not “manipulation.” It’s helping the market become more informed.

A billionaire like Ackman, of course, could probably rattle investors and get enforcement agencies interested to some extent with his name alone. But a scrappy, awkward then-borderline nobody like Martin Shkreli? No investors are going to march along behind him unless they think he has a solid thesis. 

And certainly no government entity would take a Shkreli “tip” about a company seriously…unless it was so compelling that ignoring it would be negligent, right?

A few years before making its plea about short sellers to Congress, CREW wrote a letter to the U.S. Attorney in Manhattan asking specifically that he investigate Martin’s short selling activities. The group said it had found evidence suggesting Martin “had engaged in behind-the-scenes efforts to manipulate the biotech industry market for financial gain.” 

These “behind-the-scenes” efforts again, referred to public blog posts and a petition to the FDA, which was a public document. (Not to be too snarky here, but I’m starting to wonder if CREW does not understand what “behind-the-scenes” means. Another note: Twitter is not mentioned in the letter, but I think we can all safely assume Martin was tweeting extensively about his short positions.)

While Martin later became known for investing failures — he managed multiple small hedge funds that ended up in ruin, eventually leading to his fraud conviction — CREW was complaining about his successes. One example it cited was his effort to “influence the stock price of Neoprobe,” an Ohio-based biotech that was developing a “lymph-node mapping agent” called Lymphoseek. 

“In his June 2, 2011 blog post Mr. Shkreli argued the value of Neoprobe stock was highly inflated, and predicted its price would drop dramatically because Lymphoseek would not win FDA approval as a result of numerous shortfalls Mr. Shkreli identified in the testing process,” the group wrote. “His controversial blog post sparked a sharp backlash from other investors, who argued his so-called scientific claims were biased and possibly fraudulent. In addition, several of his critics noticed he was a short seller and therefore not a reliable source.” 

“Nevertheless, Mr. Shkreli’s tactics worked,” CREW continued. “After he posted his blog on SeekingAlpha.com and filed his citizen petition with the FDA, the following day, shares of Neoprobe began to fall significantly.” 

Once again, CREW skirted the basic truth underpinning the scenario it was complaining about. Regardless of what credentialist arguments were being made about Martin Shkreli not being a formally trained scientific expert, investors saw value in his research and his claims. That’s why his tactics “worked.” If no one took him seriously, his blog posts and petitions would have made little difference in the situation.

(Neoprobe, which changed its name to Navidea, initially got a response from the FDA in 2012 pointing out deficiencies. The company resubmitted its application in November 2012 and won approval the following year.)

Unsurprisingly, the U.S. Attorney’s Office in Manhattan did not investigate or prosecute Martin for his short sales. When he was prosecuted later, it was by the Brooklyn U.S. Attorney, and for a different matter entirely – lying to investors over his past track record and what he was doing with their money.

An irony in Martin’s case is that while he blew up multiple hedge funds through bad or poorly-timed trades, he later made millions of dollars on his own short sales. I will not pretend that I know which yielded the biggest payoffs. I tried asking him, and he either ignored my question because he thought it was lazy or he just didn’t feel like telling me. (I’m sure you can ask him yourself, if you’re curious.) But I do know he made tens of millions from shorts. 

His former broker and friend Roger* (not his real name, for reasons explained in an earlier post) told me that he had as many as five winning trades in one year,  making him over $40 million. His net gains from trading in 2015 were $20 million, U.S. District Judge Kiyo Matsumoto said during his sentencing hearing in March 2017, while reciting details of his financial state of affairs.

If only Martin had managed to pull off that magic while running his hedge funds. If he had, investors may have had no reason to grumble, his fantastical projections might have turned into reality, and he might not have been prosecuted. (It may not be ethical — or always legal — but “fake it ‘till you make it” does sometimes work.)