A Biotech Short-Seller Responds to Critics

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The war against biotech short sellers is heating up once again. Short selling is never going to be a wildly popular investing practice, but it is perfectly legal and essential for the proper function of the capital markets.

But recently, a public watchdog group in Washington with no expertise in financial markets took the unprecedented step of demanding a criminal investigation of a New York hedge-fund manager simply for engaging in short selling biotech stocks. A vocal minority among Arena Pharmaceutical shareholders has taken to shouting “criminal market manipulation” to anyone who vaguely disagrees with their bull thesis; while executives from Ampio Pharmaceuticalsand Osiris Therapeutics use the fear of short sellers and accusations of stock manipulation as a rallying cry for their shareholders.

I asked a biotech short seller for his thoughts on why long investors seem so hostile to short sellers and whether this animosity will compel short sellers to be even more reluctant to voice their opinions publicly.

Here’s what he had to say (although as you might expect, he asked to remain anonymous):

“I am a money manager who runs a heavily short-biased book focused on biotech stocks. I ply my craft in relative anonymity, preferring the conversation of other institutional investors to a public forum. Being a short seller has its challenges, some of which result from the behavior of my long-only counterparts. They own stocks and resent short sellers making a case for why the stock they own is overvalued. Smart, experienced long investors, however, value learning from someone on the other side of an investment. Sometimes, the long investor will be convinced that I'm right, sell and move on. Other times, his conviction in a long position will be strengthened because he views the short thesis weak or easily debunked. The back-and-forth exchange works both ways.

“What troubles me, however, is the growing propensity for less confident long-only investors to attack the messenger — short sellers like me — instead of rigorously debating the short thesis. This bias is perpetuated by many in the media, as in a recent story about Questcor Pharmaceuticals in Investors Business Daily that was topped with the fear-inducing headline, ‘Questcor Stock Plummets After Short Seller Attacks.’

“Short sellers ‘attack’ and must be stopped, while investors (a euphemism for long-only buyers) are almost always characterized as being virtuous and good. No thought is given to the possibility that the short thesis might be correct. Enron, anyone? More alarming is how the vilification of short sellers is being pursued. The Justice Department and the Securities and Exchange Commission are urged to launch investigations into short sellers simply because they short stocks — legally. Public companies are filing lawsuits (or threatening to do so) because an investor expresses a negative opinion. In fact, in some long-only circles, any negative opinion on a stock aired publicly is automatically considered to be manipulation. Short sellers have thick skins and are certainly accustomed to a certain level of dislike from the rest of the market. No one expects CNBC to air a daily segment, ‘Short-Selling Heroes of Wall Street.’ But the trend towards criminalizing short sellers, whether it’s in the court of public opinion or through actual regulation, can cause the very market volatility regulators hope to avoid. Attempts to discredit an opinion by attacking the legitimacy of the source are only persuasive on a superficial level.

“Opponents of short selling accuse short sellers of operating in the dark and without proper disclosure. I can tell you from experience that ad hominen attacks only have a stultifying effect on the willingness of short sellers to be more visible. Who wants to make their bearish view public if it means having to defend oneself against litigation, no matter how frivolous, or a government investigation, no matter how politically motivated? All that extra work costs time and money as well as the opportunity cost. In effect, some long investors are depriving themselves of the opportunity to hear an opposing view. In many cases, this means that they will be selling their shares to a covering short seller at a price far below where they might have otherwise sold them were they privy to the short thesis. It is difficult to assess the effect of these attacks because one cannot know how many short sellers would be inclined to make their case publicly were the risk of litigation or government investigation nonexistent.

“Short sellers serve a vital function in our capital markets. They effect efficient price discovery despite our regulators’ best efforts to impede price discovery when stocks move down. Does anyone seriously think we will see a downtick rule when stocks are up greater than 10 percent? Or a loosening of the rules governing stock borrowing? For long-only investors who would like to see the voice of short sellers squelched, I say listen to Ayn Rand: ‘You can avoid reality, but you cannot avoid the consequences of avoiding reality.’ ”

—By TheStreet.com’s Adam Feuerstein

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Adam Feuerstein writes regularly for TheStreet. In keeping with company editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet. He also doesn't invest in hedge funds or other private investment partnerships.