Denial: The Role of Naked Shorting in the Fall of Martin Shkreli

Denial: The Role of Naked Shorting in the Fall of Martin Shkreli

The U.S. Attorney for the Eastern District of New York indicted Martin Shkreli and Evan Greebel on Thursday, December 17.

Greebel is a former partner at the multi-national law firm of Katten Muchin Rosenman LLP. Most of the press attention thus far has focused naturally on Shkreli rather than on Attorney Greebel, not just because Shkreli was the principal of the pertinent entities but because Shkreli had placed himself squarely in the public eye three months before, when a company he controlled, Turing Pharmaceuticals, increased the price of a drug used in the treatment of AIDS patients by more than 5000%, from $13.50 to $750 per pill.

The indictment, however, is not about price gouging. It’s about securities fraud, and specifically it’s about a scheme to defraud investors in Shkreli’s hedge funds, MSMB Capital and MSMB Healthcare.

Derailed by the ‘Boy Genius’ Angle

The case comes at a time when “failures to deliver” (short sales that are not settled properly, a consequence of naked shorting) has begun to receive a new level of attention from regulators. Shkreli may perform an accidental hygienic function by enhancing the visibility of that issue in the public at large. Or that would be possible if the public could get over the “boy genius” thing.

The mainstream media loves the idea of a “boy genius” investor/trader, and it loves the stories that result when someone it has built up as a BG falls from grace. That has been the frame for all too much of the discussion of Shkreli, since even before the price-gouging brouhaha.

Bloomberg, in a profile of Shkreli in April 2014 (well before the AIDS-related notoriety) played up the BG angle in two ways. On the one hand, although Shkreli was a little old to be a “boy” when the story went live –he was 31 – he looked a lot younger. When interviewed by reporter Paul Barrett, he was wearing a hoodie! And he could easily have passed for an undergraduate!

On the other hand, the story emphasized that he once had been a boy genius for real. Seventeen is a “boy” as these things go. Bloomberg retailed the story that he had at that age been a precocious intern to Jim Cramer, and had made a valuable recommendation to Jim on shorting a biotech stock.

When, half way into the story, Barrett gets around to actually using the phrase “boy genius,” he puts it in sanitizing quotations marks. Further, he attributes the phrase to Shkreli’s own subordinates. Talking up the boss … how unusual!

In September of this year, though, as the storm over Turing Pharm’s pricing was about to hit, Andrew Pollack and Julie Creswell of The New York Times used the phrase “boy genius” in the lede of a profile, without quotation marks. Shkreli had made it.

Back on the Rails

Let’s get back to the failure-to-deliver matter though. The indictment charges that on or about February 1, 2011, Shkreli took a large short position in Orexigen Therapeutics (OREX) on a brokerage account that his MSMB Capital maintained with Merrill Lynch. Shkreli had not actually located the ORX shares to borrow: that is – although the indictment doesn’t use the language – his position was naked. Further, Shkreli and MSMB falsely maintained to Merrill Lynch that it did have cover for these positions.

OREX had taken a very sharp fall in late January of that year, all the way from a high of $9.54 to a close of $1.77 on the final day of the month. It may have seemed an easy bet that the fall would continue. But it didn’t. Heading into February, the price stabilized. At the left hand edge of the stock chart at the top of this story, you’ll see the sharp drop, and then the brief plateau that came into existence precisely at the moment when Shkreli was betting it wouldn’t.

MSMB defaulted on its position, and Merrill Lynch had to take a loss of $7 million. Due to this and related developments at the same time, the value of MSMB Capital’s bank and brokerage accounts fell from $1.12 million to just $58,500 in the month of February alone. Also, MSMB stopped trading. In effect, it was done.

If the indictment is accurate – the burden of proof is of course on the prosecution and there has been no trial at which that burden could have been satisfied – this was a fateful moment for Shkreli and Greebel. They responded to this set-back with what a Freudian would surely recognize as Denial as a defense mechanism. They acted – and presented numbers for the relevant entities to the public – as if nothing of the sort had taken place.

The Words of the Indictment

In the words of the bill of indictment, “For months following the complete loss of the investments in MSMB Capital and the end of trading activity, Shkreli continued to send fabricated performance updates to [investors] that touted profits of as high as forty percent since inception.  For example, on or about April 10,2011, Shkreli sent an email to Investor 2 … whose identity is known to the Grand Jury, informing him that MSMB Capital had returned a profit of 8.93 percent since the beginning of the year and a profit of 42.57 percent since inception on November 1, 2009.”

The issue of naked shorting, and the sort of painful short squeeze it can make possible, arose again in the “boy genius’” life quite recently: just last month. This time he was on the opposite side: he was on the long side, and apparently in a position to do the squeezing, in connection with the biotech penny stock Kale Brothers (KBIO).

Kale Brothers, though, is a different story, one worthy of treatment under its own heading.

The takeaway from the above tale, though, is this: there was never any ‘genius’ in Shkreli, boyish or otherwise. It doesn’t take genius to make losing bets, and it sure doesn’t take genius to leave those bets uncovered, or to lie about what you’re doing.

The takeaway, too, may be that Denial is a dangerous and powerful mechanism of which one ought to be wary, in counter-parties and in one’s self.

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