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Mark Mitchell




06/30/09 at 5:28 PM CDT



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The Madoff Exemption and the Story of Dendreon (Chapter 2)

In January 2007, some 15 months after CNBC’s Jim Cramer announced that the FDA had rejected Provenge (even though the agency had not yet reviewed Provenge), the FDA assigned “priority review status” to Dendreon’s application to have the drug approved. Such status is typically granted to drugs whose trials suggest that they can significantly improve the safety or effectiveness of treating a serious or life-threatening disease. Some weeks after receiving “priority review status,” Dendreon announced that an FDA advisory panel would meet on March 29 to vote on whether its treatment for prostate cancer should be approved.

FDA advisory panels are made up of doctors and scientists who are employed on a one-time basis to review a new drug. Their decisions are not binding, but in 97 percent of all cases, the FDA follows the advisory panel’s recommendations. Given that Dendreon’s data results had been strong enough to cause the FDA to fast-track things by granting “priority review status,” it was widely expected that the advisory panel would vote in favor of Provenge, and that the drug would get FDA approval soon after. This was very good news.

Normally, this would be a time for short sellers to close out their trades. Companies receiving priority status (moving them down the road to FDA approval) generally see their stocks soar in value, and typically the prices stay at peak levels, at least until the companies present plans for how they are going to bring their drugs to market.

But in the middle of that March, there was a strange occurrence: short selling in Dendreon began to increase at an unprecedented rate. Illegal naked short selling increased as well.

SEC data shows that on March 16, 2007, over 1 million Dendreon shares “failed to deliver” – because they were sold short by people who did not possess any shares. That is, these naked short sellers took investors’ money but delivered…nothing.

The numbers rose steadily, so by March 28, the day before the advisory panel vote, more than 9 million phantom shares were circulating in the market. And consider that the SEC data might understate “failures to deliver” by factors of ten or more. So by that point the market may actually have been flooded with about 90 million phantom shares – in a company that had only 100 million shares outstanding.

On the night of March 28, 2007, Cramer commented on Dendreon again. He did not mention the phantom stock  (in May, 2008, he began a “crusade” against naked short selling, but he started this “crusade” just one day after he was exposed by Deep Capture as a central player in a media cover-up of the naked short selling scandal). Instead, Cramer offered the long-shot prediction that the FDA advisory panel would not approve Provenge. He advised Dendreon’s shareholders to “SELL, SELL, SELL!!!”

This was the “battleground.” And Dendreon was under attack.

* * * * * * * *

The next day—March 29, 2007–the FDA’s advisory panel decided overwhelmingly in Dendreon’s favor. Every one of the 17 scientists and doctors on the panel voted that Provenge was safe, and 13 of the 17 panelists voted that there was substantial evidence that the treatment effectively lengthened the lives of prostate cancer patients.

As you will recall, the FDA had followed the recommendations of advisory panels in 97 percent of all cases. So at this point it seemed extremely likely that Provenge was on the fast track to approval. Most experts expected that Dendreon could begin delivering its treatment to prostate cancer patients within six months. The company’s stock price, which the short sellers had depressed to $4 before the panel vote, now soared.

By April 13, Dendreon was worth around $20 a share.

But the short sellers did not relent. The more the stock rose in value, the more they piled on, flooding the market with still more phantom stock. On the day after the advisory panel meeting, at least 9 million phantom shares were sold, according to the SEC’s unforgivably incomplete data. During the following two weeks, between 9 and 10 million shares were “failing to deliver” on any given day. And on one day, April 13, overall short interest in Dendreon rose to 32 million shares – from just 8 million shares a few hours before.

By any reckoning, this was sheer insanity. Given Dendreon’s prospects for FDA approval, it seemed like the short sellers were flushing money down the toilet. Some observers racked it up to psychology – the short sellers had grown emotionally tied to their positions, and simply could not give them up.

But I offer several other possible hypotheses, which are all mutually compatible. The first is that the short sellers believed that they could generate enough phantom shares to drive the stock price back down, despite Dendreon’s fantastic news. The second is that the short sellers were aware that there was about to be released a wave of lopsided negative financial research and media reports (including more from Cramer) that they expected would crack the stock.

And the third explanation is that the short sellers who made this long-shot bet perhaps knew something that the rest of the world did not. They perhaps knew that some strange occurrences were imminent, and that these strange occurrences would diminish Dendreon’s prospects. And given the especially sharp increase in short selling on the morning of April 13, they might have expected that the strange occurrences would begin on that particular day.

Alas, something strange would indeed occur later on April 13, 2007. And after that, there was another strange occurrence – then still more strange occurrences, one after the other until it seemed that Dendreon and its treatment for prostate cancer would no longer exist.

I will describe these strange occurrences, but first we must understand a bit more about a network of smooth market operators and a “prominent philanthropist” named Michael Milken.

* * * * * * * *

As mentioned, we do not know who was responsible for the illegal naked short selling of Dendreon. The SEC keeps that a secret.

But while the SEC is of no help, most any Wall Street broker can describe several “proprietary” strategies that are popular with unscrupulous hedge funds.

One such strategy is known as a “married put.” Normally, a hedge fund buys from a market maker a certain number of put options—the right to sell a stock at a specified price at a specified date. If on that date the stock has lost value to the point it is below that specified price, the buyer of the put option (the hedge fund) makes money, and the seller (the market maker) loses money. To hedge the risk that he might lose money, the market maker, at the same moment that he sells the put option,  also short sells the stock. This is perfectly legal.

But some market markers conspire with hedge funds to drive the stock price down. Instead of merely shorting the shares into the market, the market maker naked short sells the shares, and, importantly, sells those phantom shares to the same hedge fund that bought the puts. As a result, the hedge fund manager winds up with the puts and a matching number of shares (actually phantom shares that are never delivered to him, but about which he never complains, or forces delivery, as that would create upward pressure on the stock, the precise opposite of what he wants).  Because the puts and the phantom shares are equal in number and arrive together at the hedge fund, they are known as “married puts”.

Once in possession of the phantom shares, the hedge fund manager proceeds to fire them into the marketplace. But he is able to say that he never naked shorted because all he has done is sold the shares that he bought (wink wink) from the market maker.

Either way, the effect is to flood the marketplace with phantom stock. The hedge fund makes money. And the market maker is rewarded with more business selling married puts.

Incidentally, the fee charged for such puts do not follow any normal option model pricing (in fact, the exchanges search for married puts by looking for options that are mispriced in relation to Black-Scholes, the standard formula that prices options). That is because their pricing is not really a function of any math or statistics, but is a function of the willingness of the hedge fund to pay the option market maker to help him break the rules against naked short selling. And that willingness is a function of how difficult it is for the hedge fund to use other loopholes to break those rules.

In the slang of Wall Street, these married puts are known as “bullets.” Through their maneuverings, the option market maker and hedge fund manager synthesize a naked short position that puts “bullets” into the hands of the hedge fund. The hedge fund fires those “bullets” at the stock to make it collapse, timing the last “bullet” to fire as the hedge fund’s put option expires profitably. If the option position nears expiration and looks like it will expire at a loss (“out of the money”), the hedge fund manager goes back to the option market maker, and together they reload by synthesizing more “bullets.”

Until recently, this behavior flourished owing to the “Madoff Exemption” – a rule that the SEC named after a “prominent” market maker and investor named Bernard Madoff. Mr. Madoff had considerable influence at the SEC, and helped the commission write the rule that carried his name. This was before Mr. Madoff became famous for orchestrating a $50 billion Ponzi scheme with help from the Mafia (CNBC’s Charles Gasparino has reported that Madoff might be tied to the Russian Mafia; whistleblower Harry Markopolis stated in Congressional hearings that Madoff appeared to have ties to the Russian Mafia and Latin American drug gangs; and Deep Capture’s own investigations suggest that Madoff did business with multiple people with ties to both Russian and Italian organized crime).

The “Madoff Exemption” permitted market makers (e.g. Madoff) to sell stock that they did not possess,  so long as they were doing so temporarily to “maintain liquidity.” Abusing that exemption in order to facilitate naked short selling in cahoots with hedge funds looking to drive down stock prices was blatantly illegal, but the SEC looked the other way, even as market makers failed to deliver shares for weeks, months, and even years at a time. If anyone raised a fuss, the hedge funds would say that the phantom shares didn’t originate with them, the SEC would say that stock manipulation is hard to prove, and the market makers would say that they weren’t breaking any rules.

After all, they had a “Madoff Exemption.”

* * * * * * * *

At any rate, in March 2007, with Dendreon seemingly on the fast track to FDA approval, most traders were rushing to buy the company’s shares. A specific set of hedge funds, however, purchased large numbers of put options in Dendreon. Without a subpoena, we cannot say for sure whether the put options they bought were married to naked short sales, but simply from their put activity it is clear that these hedge funds were placing quite large bets against Dendreon, and they maintained these positions even after the FDA advisory panel voted in favor of Provenge on March 29.

To understand how completely anomalous these bets were, consider that in the entire universe of 11,500 hedge funds, only ten held large numbers (more than 150,000) of put options in Dendreon at the end of March 2007. Two of those ten funds held relatively few (200,000 each) put options in Dendreon and cashed out soon after the FDA advisory panel meeting. They do not appear to have otherwise been major traders in Dendreon, so I will not mention their names.

One of those ten hedge funds is Apollo Medical Fund Management, which is managed by a man named Brandon Fradd.  Fradd was once accused of burning documents relevant to a civil court case. Fradd was also once the limited partner of a criminal named Reed Slatkin, who was indicted for orchestrating the third largest Ponzi scheme in history. But Slatkin seems to have had minimal involvement in Apollo’s trading, and I have yet to uncover any evidence proving that Apollo is tied to naked short sellers or others in the network that this story intends to document. So let us give Fradd the benefit of the doubt.

Let us focus instead on the remaining seven of the ten hedge funds that held large numbers of put options immediately after the FDA’s advisory panel handed Dendreon its fantastic news, which was right at the time that Dendreon was bombarded by illegal naked short selling (phantom stock), and just before Dendreon was to experience some strange occurrences.

The managers of these seven hedge funds all know each other well. They have all worked with Michael Milken or Milken’s close associates. They include the following:

  • a fraudster and naked short seller who is believed to have stolen billions of dollars with help from Russian and Italian organized crime;
  • a trader working for a man who once managed, along with his father-in-law, the dirtiest, Mafia-linked brokerage on Wall Street.
  • a trader who co-founded his fund with a man who was jailed for plotting to murder Michael Milken’s famous co-conspirator, Ivan Boesky;
  • a man who became the “most powerful trader on the Street” after working for one of the most notorious, Mafia-linked brokerages on the Street;
  • an accused naked short seller who was at the center of the greatest scandal in SEC history, and is now under criminal investigation;
  • a fellow who once owned a fund that was charged in a massive naked short selling fraud and was later mixed up in a Mafia-connected, criminal naked short seller’s scheme to bribe agents of the FBI; and
  • a Russian “whiz kid” who was the top trader for a man who once worked at a notorious Mafia-linked brokerage—the same brokerage that once employed the criminal naked short seller who bribed those agents of the FBI.

Again, judging from SEC disclosures of put option holdings, these seven colorful traders (plus Fradd, whom I have yet to tie to this network) were the only hedge fund managers on the planet who were placing serious bets against Dendreon after the FDA’s advisory panel voted in support of Provenge.

So let’s get to know more about these seven colorful traders–and then let’s try to surmise whether they knew about the strange events that were about to occur in the Spring of 2007, and whether those strange occurrences had anything to do with a “prominent philanthropist” named Michael Milken.

* * * * * * * *

This is part 2 of a 15-part series. The remaining installments will appear on Deep Capture over the next several weeks, after which point the story will be published in its entirety at DeepCapture.com. It is a story about the travails of just one small company, but it describes market machinations that have affected hundreds of other companies, and it contains a larger message for anyone concerned about the “deep capture” of our nation’s media and regulatory bodies.

Mark Mitchell is a reporter for DeepCapture.com. He previously worked as an editorial page writer for The Wall Street Journal in Europe, a business correspondent for Time magazine in Asia, and as an assistant managing editor responsible for the Columbia Journalism Review’s online critique of business journalism. He holds an MBA from the Kellogg Graduate School of Management at Northwestern University. Email: mitch0033@gmail.com


The SEC may be finally doing something proactive. Just read SEC requested a copy of STOCK SHOCK--new movie about market manipulation. satwaves.com/bl...lling/     Go Mark and Stock Shock!


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Jennifer Dajo






06/30/09 at 7:57 PM CDT

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