Borrowed Shares

Once in a while, you find a short that is so attractive, you wonder how anyone in their right mind would want to be long this piece of trash. KaloBios Pharmaceuticals (KBIO) fit that bill perfectly. Before we look at what happened, it's important to preface it by saying that KBIO did indeed declare bankruptcy1.

Infinity Squeeze

It wasn't a straight ride down to zero for KBIO. On the evening of Friday, November 13, 2015, the company announced it was winding down operations and liquidating its assets. After 2 failed cancer drugs, management was throwing in the towel and laying-off most of its employees. At the time, the stock was trading at about $1, with minimal volume (about 150K shares per day).

Following the ominous Friday-night announcement, the stock opened the next Monday at $0.44, or down more than 50%. That's where Martin Shkreli (aka the Pharma Bro) comes in. Shkreli stealthily purchased 70% of the shares (80% of the float) on the open market after the stock initially plunged. On Monday, November 16, more than 3.5M shares were traded, and to everyone's surprise – except Shkreli – the stock price rebounded quickly to close at almost $2. Investors had not way to explain the strange price behavior. 

Busted bio-techs don't normally double in price; they usually fall 50% to 70% on the first day, then keep falling until investors can access the market value of its assets (be it a manufacturing plant, high-tech testing equipment, a research lab and anything else that isn't rented). In KBIO's case, the company had announced it was looking for "strategic alternatives", a euphemism for shopping around its patents in the hopes of finding a bidder, any bidder. At KBIO, nobody was interested in putting in an offer (most bio-tech intellectual property is company-specific), meaning all that was left was the company's shell value (i.e. the stock listing could be used by another company looking to go public quickly, without having to go through an invasive and time-consuming IPO – a private company like the Shkreli-owned Turing Pharmaceuticals). A shell is usually worth between $300,000 and a million (which would presumably be going to creditors, before shareholders saw a single penny). The best equity holders could hope for was a fire sale of unencumbered assets to generate a decent chunk of change (I doubt the things laying around the office, like lab coats and beakers, could even reach seven figures, but you never know).

Over the next two days, daily volume was 5M and 7M shares, respectively. Wednesday evening, Shkreli filed his mandatory paperwork with the SEC, and the cat was out of the bag.  The ensuing price run-up on Thursday, November 19, was epic. The stock opened at $14, with over 12.5M shares traded on the day. On Friday, it closed at $18, with another 13M shares changing hands. The next Monday, the stock reached an intraday high of over $45, with another 17M shares being traded. Then, trading subsided (and KBIO was eventually halted, then delisted), never to reach those levels again. At a market cap of almost $200 million, KBIO was overvalued by any available metric.

Short Selling Danger

Joe Campbell, a 32-year-old small-business owner from Arizona, shorted $33,000 of KBIO in his E-Trade account on November 18 (at about $2 per share). After the close, KBIO announced interest from Shkreli & Co. in acquiring the company. In after-hours trading, the stock reached $16, turning Mr. Campbell $37,000's account balance into negative $100,000 (E-Trade made him cover at $18.50, taking his total lost to a whopping $106,000). He was hardly the only short seller burned by Shkreli's market manipulation. That's a 800% spike with no regular-hour trades in between (to trip stop limit orders). Then Shkreli stopped lending his shares to short sellers, making the situation worse. 

Some short sellers got ruined. The SEC isn't in the business of protecting short sellers, so tough luck, despite the overt stock market manipulation. What's the point of being right if you are broke! It's a reminder to always size your short bets at no more than 10% of your portfolio; even slam dunks like KBIO (which went up 10,000% in 5 trading days). As for Shkreli, after clearing out the board of directors and appointing himself CEO of the company, he was arrested on an unrelated matter a few weeks later. The company fired him for cause and it was the start of KBIO's slow decent. As majority owner, he had promised an substantial equity investment to turn the company around, but that fell through. Ultimately, Shkreli ended convicted to 7 years in prison (but not for this shady behavior).

Cost To Borrow

When the KBIO saga began to unfold, the rebate rate on short sales was an annualized 24% (according to MoxReports, only 6% of the shares were shorted at the time). The borrow fee rose mildly to 28% on Friday, November 20, 2015. The next Monday it skyrocketed to 201% and available inventory was cut in half. For the rest of the week, KBIO was unavailable for shorting. The shortage of borrowable shares continued until KBIO was delisted, with the occasional inventory popping up from time to time, but at a rate of 150% to 200%, it was a pretty expensive short. Not to mention the buy-in risk involved!