Casinos, Markets, and the Philosophy Of Manipulation

By Bob O'Brien
Sunday, April 10, 2005

You enter through the brightly illuminated double-doors, and enter a land of limitless possibility - lights blink, bells chime, coins hit their attendant cups with a jingle, comely hostesses offer free drinks, everyone is a winner. Smiling, laughing faces of preternaturally beautiful people beam at us from placards and signage, assuring us that we are all victors, as they were in the genetic lottery of life.

This is the casino’s pitch. We know it is a lie – we hear the piped-in sound of jackpots going off, see the obvious artifice at work. We understand that the house has an edge, and statistically has to win more often than not in order to stay in business and pay for the AC and the dealers and the electricity.

We know that the marketing conflicts with what we observe to be the actual patrons of the place - obese, chain smoking blue-haired septuagenarians with walkers and skin conditions and halitosis. We apprehend that we are being marketed a tonic of questionable value. But we are OK with that, because the amusement factor is high, and the casinos aren't allowed to cheat.

Not outright. They can't mark or count cards, apply pressure to the roulette wheel, load the dice, rig the machines. There are protections in place, they get an actuarial edge, and we pay if we choose to frequent the establishments, ostensibly for the entertainment value therein. The odds are known to us, and we get that they aren’t in our favor.

The equities markets are a bit different. And yet there are similarities. There is the possibility that one can get wealthy through good fortune, or at least without having to go to work. There is a marketing effort that encourages us to put our money onto the gaming table, that it’s the prudent thing to do - to be an "investor." There are pundits and talking heads and media personalities and analysts and advisors and brokers and fund managers and facilitators at every level to enliven and reinforce our decision to invest. There are plentiful studies that advance the wisdom that having money in the market makes good sense.

We have a regulatory net that is supposed to police the playing field, and we are told with regularity that they are doing so with diligence. We have the tacit imprimatur that all is well at a macro level, and that we can buy a piece of a company, invest in its future, with an assurance that criminals cannot simply steal our money with impunity.

The whole system is predicated on perpetuating that perspective, as otherwise it would be difficult to convince folks to put their savings into equities, and the market requires a steady stream of new money.

Welcome…To The Machine

A company goes public in order to raise capital and to create a liquid market for its shares. It gets a higher multiple as a public company, which reflects the liquidity of an investment through efficient markets versus a private investment where there is no easy mechanism or venue for exit. In early-stage companies, where there’s a technology development cycle that requires access to capital, or a latency between creation of IP and ability to monetize the IP, the idea is that the company can leverage their future income potential, in order to fund development today. Companies like DEC and Microsoft and Genentech highlight where this theory has been translated into reality, and the original investors were handsomely rewarded.

During the dot com bubble, this speculation in the future value of today's IP became an intoxicating elixir that was guzzled with abandon by novice investors convinced that their time had come, and that anyone could make money in the market. Those were heady times.

Everyone has a story of how they fared when it all came crashing down, as bubble speculations inevitably do.

But the fundamental idea is a sound one. Companies win, and so do investors.

In theory.

There are some hitches, however, in that occasionally companies are larcenous, and misrepresent their value or their prospects. Promoters will tout stocks, and mislead us as to the soundness of propositions. Larceny is not unheard of in the corporate world. Out of every X number of companies, a certain number will be deceitful – companies are simply microcosms of civilizations.

An entire machine has been developed to extract dollars from the buying and selling of stocks, wherein no value is added to the proposition, at least no value in terms of the creation of a tangible. Speed has increased, ease of making transactions has improved, access to money and research and data have seen quantum leaps forward, but at its essence those are value-ads to the business of buying and selling stocks.

The business has gotten much, much larger than anyone envisioned over the last 25 years, and the industry has increased its capacity to accommodate the scale. It has been largely successful, but at the same time, parabolic growth has introduced a new variation of an old problem.

Money Talks

In any endeavor where large sums of money are in play, there will be those who behave criminally and unethically. It's a human constant. There will always be those who wish to make more by doing less, and who are impatient for their reward, want a shortcut, and are untroubled by moral or legal concerns.

The US equities markets are a magnet for those who understand that vast fortunes can be built if one is willing and able to game the system. The rules and regulations against doing so are inadequate disincentives to many of these players, as in a pure risk/reward equation the penalties are ludicrously paltry compared to the payoff. A mindset can prevail where only an idiot wouldn't be making some of the easy money to be had.

Our regulators are the guardians at the gates against these predators, these parasites in the system that feed upon and drain value, and productivity, and industry. Left unchecked, some parasites will kill their host, as their greed knows no bounds, and they are by definition opportunistic afflictions in it for immediate gratification. That's why they are sponges, rather than productive members of the system.

Securities regulators are chartered with keeping the public companies honest, and in policing the trading machine to ensure that the expected and predictably larcenous participants are kept in check.

The system falls apart when the regulators become co-opted by the participants, and mistake the predation of the parasites as a positive: that the parasites are simply accelerating the demise of flawed models, and serve a useful role in assisting the regulators in uncovering fraud.

I believe that this mindset has become the prevailing one for our securities regulators, and that belief is fortified by the statements of the SEC in the Euromoney article I reference in an earlier Sanity Check editorial. This mindset can translate into a climate where larceny becomes the baseline for the industry, is pervasive at every level, and is viewed by those chartered with grooming the system as a necessary and acceptable condition.

This environment is a toxic soup of chicanery and duplicity, wherein the rubes that are required as grist for the mill are assured that all is well by those who would prey upon them, and the regulators reinforce that dishonesty in order to protect their power base, their influence, and their existence.

Hedge Funds and the Madness of Crowds

Hedge funds are the latest example of unbridled power and influence trumping the best of systemic intentions. A novel industry has evolved wherein huge sums are controlled by entities with little or no oversight, and nobody is really asking where all the money comes from. While I believe that most hedge funds are honest and upright, it only requires that a small percentage be bent, in order for the system to be compromised.

When the numbers easily run into the billions, and there is essentially no regulation or constraint upon the source of or use of the funds, there is a natural attraction for crooks. Any time you have a conduit without real monitoring or safeguards, it does not demand much imagination to speculate on where a decent percentage of the money from the drug economy goes, or the illegal arms trade industry, or petro-dollars being laundered for use by terrorists. Money needs to make more money, and when the numbers are big enough, the predators emerge.

So here we are. Nation-state sized dollars are being used to short companies, some of which are no doubt scams and shams, but the majority of which are simply vulnerable due to their stage in the development cycle. Abundant evidence exists to support the theory that a substantial amount of illegal short selling is being conducted in a strategic manner, to destroy smaller public companies. Links between the media, class action attorneys, regulators, analysts, market participants, banks, politicians and the phenomenally wealthy hedge funds are easy to spot in the recurring attacks containing all the same elements and players.

The Reg SHO Threshold list is simply a binary confirmation that “selling that which one does not own” - failing to deliver, or naked short selling, or fraud (in layman’s terms) - is a regular practice. There’s no argument, simply discord over the level of abuse and at whose feet to lay the blame.

Scholarly abstracts are manifest from academicians observing and commenting on the extent and profitability of the manipulations. The financial engine of our country is being subverted, and used to destroy companies in the exact stage that they are most in need of an accommodative environment. Countless innovations are being lost to bankruptcy and a failure to obtain necessary follow-on funding, and we as a country will be the poorer for it. In today’s environment a Microsoft or an Intel or a Genentech couldn’t survive, and our future prosperity as a nation is being mortgaged so that a select few can prosper.

The business of serial-killing companies in order to benefit from the decline in their stock price has become a mainstream industry, and there seems to be no appetite from the regulators to stop it - the extent of the problem is likely so large that a systemic collapse could be in the offing were all facts known. Hence a push to ensure opacity in a system that should be transparent, and a breezy desire to "just put things behind us and move forward" by our regulators. If they had been doing their job the current state of affairs would have been impossible to arrive at, and they are eager to avoid examination of their collective failings.

Is The Best Defense Really No Defense?

So what can a company do to protect themselves from the marauding intent of rogue hedge funds? The popular wisdom that has been propagated and reinforced by an industry intent upon squeezing every last drop of profitability out of illegal manipulations, is do nothing. The bad guys have ensured that plentiful articles abound, proclaiming the inadvisability of mounting any defense other than running the company and letting the numbers do the talking.

Statements from the media and academics regularly appear to reinforce the idea. Attorneys celebrate it, as their clients can't be sued for keeping their heads down and doing nothing to aggravate an already negative situation. It is reasonable legal advice, but in my opinion, terrible business advice. Then again, most attorneys have never run a business.

The truth is that we don’t see much change in the manipulators’ play book because the tactics they employ are so effective. They target companies of a certain size and at a certain stage in their development, secure in the knowledge that the victim will lack the skill-set and the bandwidth to mount a competent defense.

They are unwittingly aided in their assault by the management teams, who inevitably are ill-equipped to respond to the attacks. The CEO’s are typically very smart, very stubborn guys who believe that they can win if they just stick to running their company as best they can. Again, that is reinforced and played to by the industry’s observations. The management teams want to believe that they can ignore the threat, and that eventually fundamentals will rule the day; and they are assured that is the best course of action at every turn, which in turn validates their bias.

In my experience you can’t con someone without their help; it requires one’s active participation in deluding oneself to buy the real whoppers. The manipulators know this, and understand the audience they are playing to - the prevailing mindset that they can exploit for their benefit.

Most management teams believe that they are different, and that unlike all the other companies who have been driven out of business or relegated to the pink sheets, they will prevail – ignoring that all the other management teams believed the same thing. They don’t teach this in business school. There’s no knowledge base to draw from, no institutional memory, and by the time they have the experience, they are likely road-kill.

They Asked For It

Blaming the victim is popular, both for the system, as well as for the companies that are looking for proof that they are atypical.

If all those other companies were scams, or bankruptcies waiting to happen, then there’s a facile excuse with which to comfort oneself. It offers the companies hope that because they are different (ostensibly), they will likely be spared the same fate. And it offers regulators a pretense to hide behind – it is a blend of classical logical fallacies, that of the undistributed middle (syllogism), and of affirming the consequent (non-sequitur): “Many companies that were attacked and ultimately failed were scams; most scams are ultimately discovered and attacked, therefore if you are a company under attack you are likely a scam.” Or: “If you are a scam you’ll attract an attack; you are under attack, therefore you are a scam.” Or my personal favorite variation on the non-sequitur theme: “Shorts often know something is wrong with a company; shorts say something is wrong with you, therefore there is something wrong with you.”

Manipulators have an additional arrow in their quiver, which is the understanding that most companies of a certain size have no experience with the threat they are dealing with, thus misunderstand the scope and severity of it - and lack the financial and personnel resources to fight back. This is key. Manipulators want easy targets. Like all criminals, they seek low hanging fruit. That’s why they generally don’t go after strong, established, well-funded large companies unless the target is in a pronounced crisis. They dislike a fair fight. It reduces their odds of winning. And an easy win is what they count on.

The experts in the field, invariably attorneys whose expertise is self-declared, or based upon some contact with companies in crisis, will tell the companies to do nothing. Their reasoning is simple: the company never has the internal resources to implement convincing countermeasures, will dilute its focus if it becomes engaged, and will be inept in any efforts it mounts. So doing nothing is better than doing something poorly, which will be equally ineffective as the "do nothing" solution, but provide additional opportunity to the manipulators. So take the safe route. I can’t argue that, and I’d probably advise the same thing for many, as if you are a software developer or a mortgage lender or a food producer you likely lack the expertise to be effective. The problem is that you are just as dead at the end of the day if you take this route - you'll just suffer less collateral damage on the way to the morgue.

I’ve heard folksy wisdoms espoused, like, “don’t wrestle a pig – you get dirty and the pig enjoys it.” Cute homily, but incorrect and inappropriate. A better metaphor would be that of an explorer who just waded through a river, and finds himself covered with leeches. What should he do? Drink lots of orange juice, work out, take vitamins, and keep on exploring? Incredibly, that is what the parasites have advanced as sage advice.

Here’s a news flash: if you don’t take informed, effective steps to rid yourself of parasites, they will eat you alive. That’s been my experience looking at hundreds of companies that have been run out of business or onto the pink sheets. And yet, for fear of appearances, most companies will choose to do nothing in the hopes that a bright, motivated, experienced team working 24/7 to destroy shareholder value won’t be able to achieve what they clearly have been successful at doing hundreds of times in the past.

Another variant of the logical fallacy advanced by manipulators is that if a company complains about short sellers illegally attacking them, then they are likely scams. The fallacy here is an easy one to spot: “Past scams have protested that short sellers were to blame for their woes, therefore if you protest, you are a scam.” And yet as obviously laughable as that fallacy is, it’s a powerful deterrent, as many companies that are being manipulated, are on the Reg SHO Threshold list, are being unfairly castigated in the press and by biased analysts, will take a strong and silent posture, for fear of being branded a scam. Ludicrous, but that’s the system – if you scream rape, you are likely going to be called a woman of ill repute, so be quiet.

It is an affront to any pretense of fairness or reasoned process, and yet that’s the way it is. And the regulators support this witch-hunt approach to justice – if you complain you are guilty, and if you don’t complain and are driven out of business you were likely guilty. A nice package where the company is always wrong, brought to you by the regulators who are supposed to be ensuring an even playing field.

Wearing The Target Down

The onslaught of a sustained, ongoing manipulation will weaken most companies, either by wearing their investors out, or wearing the management team out, or creating enough business issues for the team to have to contend with so that their very existence is jeopardized. It is not unheard of for class action suits to be filed solely to affect stock price, investigations to be launched solely to cause problems for the company (in getting key orders, or funding, or to impact customer relationships – there have been instances where investigators called key customers of companies to inquire whether they knew anything about suspicious activity – a surefire way to kill a relationship), stories to be planted in order to hinder pricing of secondaries. All’s fair when you are trying to crush the victim like a cigarette butt.

Manipulators will make money as the stock falls, and when the stock rises. The art is in knowing when the stock will move in a particular direction. Which, on a thinly traded issue, you are in a position to know if you are coordinating the manipulation. So money will be made on call options or by selling puts when it’s time to let the stock go up some, and on short sales and by buying puts and selling calls when it’s time to drive the price down.

The thing that most companies don’t realize is that it doesn’t matter what business the company is in, how strong their fundamentals are, or how savvy their team is. The manipulators couldn’t care less. It is irrelevant. They are using the company’s stock as a vehicle to make money, nothing more, nothing less, and it doesn’t matter if the company has the cure for cancer or is all sizzle and no steak – they will be treated identically.

Ultimately the goal is to demolish the company and put them out of business, but that goal is only an imperative for a certain type of manipulator. For the better-funded and more sophisticated crooks, the juice is in sustaining the up and down cycle of the stock movement – no final death blow is required, nor even necessary. The event horizon for these manipulators is multi-year, and they make money in all markets. They can afford to wait to capitalize on any bad news for the targeted company, or the sector, or the economy, or any macro events. In the mean time they can make the rent by swinging the stock around. All they require is a steady stream of investors to fleece.

Eventually the cycle results in the targeted company’s investor base becoming disenchanted, of the belief that nothing can save the company, that fundamentals don’t matter, that the only news is bad news. Manipulators accentuate negative moves, as there are few investors desirous of “catching a falling knife,” and when the news is bad the parasites will throw their weight into selling the stock off, capitalizing on panic, creating margin calls.

The erroneous assumption by many is that eventually the manipulator has to cover – not true. If they can engineer the company going BK, or remaining in penny stock purgatory indefinitely, they never have to cover – they get to use the funds generated by selling fail to deliver shares in perpetuity, with no tax consequence, as long as the company is trading for a fraction of its past price.

The perfect case for the manipulator is if the company is ultimately de-listed – then they never, ever have to cover, although there is a question as to the contingent liability for the fails once the company goes private (de-listed), as who owes all the now private equity holders if there is a 200% or 300% or 400% overage of owners to equity? This is the realm of lawsuits, but most shareholders are wiped out by this point, as is the company, so in the end nobody has any money to go after anyone else. The only winner is the manipulator, who gets to keep all the money generated by driving the company out of business.

Abandon All Hope?

I have seen few things succeed as a defense against a manipulative attack. As previously discussed, most companies are ill-prepared for one, and puzzled as to what is happening when they are in the middle of it, and by the time they understand the level of peril they are in, it’s too late to resuscitate the victim.

Often the attacks are driven by someone desirous of acquiring the company or the technology, who points the bad guys at the victim (what hedge fund isn’t interested in hearing about a new short idea?) Sometimes it’s the company’s own investment bankers, sometimes a competitor who wants to kneecap a potential upstart before they can take market share. There are an infinite number of variations.

In the biotech and nanotech field I believe that we see a lot of this sort of competitively driven strategic manipulation. Big Pharma doesn’t like to pay retail for technology. If they can impede a company’s chances of securing funding or bringing a product to market, they can often buy the company’s assets out of bankruptcy, or for fractions of a cent on the dollar once the target’s back has been broken.

Same in the technology arena – if you could impair a company’s chances of growing into a formidable threat in your market, what dominant player wouldn’t at least consider it? Especially if there was virtually no chance you would ever get caught, or have meaningful charges brought against you? And what if you could make money doing it?

Sadly, many companies that are attacked never recover. Either their will to succeed is broken, or the will of their key investors and institutions to continue to support them is broken, or the timing of their competitive advantage is lost, or their ability to raise capital at reasonable valuations is destroyed. Employees lose ambition as their options become worthless, retail investors lose hope as their NAV declines, customers and suppliers and potential partners lose

interest in doing business with a stigmatized entity, and ultimately the weight of the onslaught diminishes the company’s prospects.

What I have described is nothing more than the bulletin board scam moved up the foodchain, now impacting companies with billion dollar market caps in addition to the microcaps trying to fund their business plan. As the money in the hedge fund world has gotten larger, so too has the requirement for targets, and bigger money can hunt bigger prey. This can only get worse before it gets better, and given the amount of leverage that many of the offshore funds use, the bankers that are supporting that leverage cannot allow them to fail – hence there is no limit to the amount of money that can be brought to bear to depress a company’s stock.

From a regulatory standpoint, a rigorous enforcement of existing delivery requirements and rules requiring forced buy-ins for fail to deliver shares is the only way to combat the trading irregularities we see in many stocks across all the exchanges. The equilibrium of market forces doesn’t work when there are a limitless number of shares that can be sold using a limitless amount of money. If the regulators do nothing and stand by while our markets are plundered, they are facilitating the wholesale destruction of American business development and innovation, and soon the only money that will be coming into our markets will be money earmarked for the destruction of companies, rather than for investment in their growth.

Time For A New New Thing

I would argue that a new paradigm is required to contend with this threat. The rules and laws on the books need to be enforced, with vigor, unilaterally, and companies need to wake up to the reality of the public landscape that they are a part of. Perhaps if enough victim companies figure it out and implement convincing countermeasures, then the appeal of savaging them for profit will be diminished, and the predators will move on to easier prey. There will always be hunters and hunted, but I would argue that porcupines get attacked far less frequently than hamsters.

My belief is that it is possible to create and implement effective countermeasures, however the companies that do so will be few and far between. Most don’t understand how the threat they are faced with operates, what its network looks like, how committed it is to the destruction of the target, how well funded it is, how its tactics can be countered. Most are hard pressed to allocate resources to deal adequately with business issues, much less to deal with what is naively viewed as a “market issue.” And by the time they wake up and realize that the “market issue” is in fact a cage fight for the survival and prosperity of the company, where their adversary is skilled, motivated, networked, well-funded, and intent upon winning, they are too far down the road and have squandered their chances for survival. Too many companies misunderstand the nature of the engagement, and the sophistication of the lineup of adversaries. Most won’t make it through the gauntlet without major damage, and many will be lost due to doing too little, too late.

The sad fact is that in many instances this is no longer about betting against a company by selling short – it’s about using every means available to destroy companies in order to create a gain. There is simply too much money at risk to leave anything to chance. The stakes are too high.

This amounts to a kind of financial terrorism, in the sense that we have become a country that sells things and services to each other, rather than a nation that builds things (other than houses.) Our strength still lies in our ability to innovate, not manufacture – we’ve delegated that to economies where the cost is lower to produce goods. Innovation requires the capability for new ideas to flourish, to find capital, to make it from the idea and development stage to the revenue generation stage. If an industry exists in our equity markets that derives its profit from destroying early stage companies, and we stand idly by as it goes about its savage and illegal business, then we are a doomed society destined to become a backwater economy – an animal that allows others to eat its young. That dim beast cannot have a very bright future.

And we deserve better.


Unless their approach to dealing with the problem changes, the companies that are targeted by manipulators don’t stand much of a chance. Doing nothing is not a defense, and the absence of a defense is an invitation to marauders to have their way with them. And we, as a nation, cannot afford to allow that to happen, as the companies that are destroyed represent our future innovations – the next Intels, and Microsofts, and Genentechs. Our intellectual property is such that it is rapidly becoming our differentiated national product, and if the market that enables its nurturing and development is systematically undermined, we will be an economy in permanent decline – new drugs won’t make it to market, new devices won’t be created, cures and improvements will remain undeveloped, better mousetraps will forever get stuck at the drafting table.

The laws need to be enforced, and companies need to reinvent their strategy for countering manipulative assaults.

No action will, in hindsight, be viewed correctly as the most damaging action of all.


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