The Securities and Exchange Commission (“SEC”), Financial Industry Regulatory Authority (“FINRA”) and New York Stock Exchange Regulation, Inc. (“NYSE Regulation”) have taken unprecedented steps in response to the concern that the stock collapse of Bear Stearns and Lehman Brothers resulted from the spread of false and misleading rumors, and that the rumors may have been linked to “naked” short selling.
- Sunday, July 13, 2008: The SEC issued a press release -- timed to precede stock trading in Asia -- stating that the SEC, FINRA and NYSE Regulation “will immediately conduct examinations aimed at the prevention of the intentional spread of false information intended to manipulate securities prices.”
- Monday, July 14, 2008: The NYSE Regulation sent a letter to certain broker-dealers (.pdf) requesting by July 28, 2008, detailed descriptions of how the firm “monitors the activities of its personnel to ensure that False or Misleading Rumors are not being circulated in order to affect market conditions or for manipulative purposes,” including “external and internal emails, vendor terminals, instant messages, message boards, internet chat rooms and PINs.” The letter also posed pointed questions, such as “if the firm utilizes software to surveil for communication pertaining to False or Misleading Rumors,” “if sales and trading personnel are permitted to use external email vendors, personal cell phones and blackberries at the firm,” or “whether the firm has policies and procedures requiring sales and trading personnel to report to a supervisor and/or Compliance any instances involving a client or internal or external member of the broker-dealer community who is engaging in circulating False or Misleading Rumors.”
- Tuesday, July 15, 2008: The SEC issued an “Emergency Order” pursuant to its rarely-exercised authority under Section 12(k)(2) of the Securities Exchange Act of 1934 (.pdf) stating: “False rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by ‘naked’ short selling.” Premised upon these concerns, the SEC prohibited naked short selling -- i.e., short selling a security “unless such person or its agent has borrowed or arranged to borrow the security or otherwise has the security available to borrow in its inventory prior to effecting such short sale” -- in 19 identified financial firms during the period from July 21, 2008 until July 29, 2008.
- Friday, July 18, 2008: The SEC issued an amendment to the Emergency Order (.pdf) and interpretive guidance on the Order. The amendment, among other things, excluded certain identified “bona fide market makers” from the “borrow and arrangement-to-borrow requirement of the Order.”
Regulatory officials have made public statements addressing these measures. On July 14, SEC Chairman Christopher Cox, in an interview with Bloomberg news reporter Peter Cook, stated that the SEC’s investigation includes “all firms - even those that we have every reason to think are following rules and doing nothing wrong - to make sure that ... this kind of rumor mongering doesn’t occur in an illegal way.” Chairman Cox acknowledged that the SEC “brought the very first case in SEC history in April of this year that imposed penalties for exactly this kind of behavior, it’s in part because it’s hard to track down that this hasn’t been done before, but we are quite serious about it, we think we have the tools to do it.”
And, a July 15th article on the website SecuritiesIndustry.com quotes John Malitzis, Executive Vice President of Market Surveillance at NYSE Regulation, saying that NYSE Regulation’s letter was posted on its website so “firms that have not received it can do some self-regulation.” Malitzis also clarified that NYSE Regulation is looking at sell-side firms while the SEC focuses on buy-side firms as “[t]he goal is to look at both sources of rumors.”
It is doubtful that many cases will be brought premised upon the spread of false rumors. While regulators have had an easier time identifying participants in suspect communications since the advent of email and instant messaging, false rumors designed to manipulate the market will likely be spread through oral, not written, communications. In addition, regulators may have difficulty proving that the rumor was “false or misleading,” and that a defendant had knowledge of the falsity and intent to manipulate the market.
There has been only one case brought by the SEC on the basis of false rumors, SEC v. Paul S. Berliner, Civil Action No. 08-CV-3859 (JES)(S.D.N.Y.). In that case, Berliner, a trader at Schottenfeld Group, LLC, disseminated a false rumor designed to cause a drop in the stock price of Alliance Data Systems Corp. (“ADS”) that was an acquisition target of The Blackstone Group (“Blackstone”), so that Berliner could profit on naked short positions that he held in the stock. Berliner transmitted instant messages to 31 securities professionals stating “ADS getting pounded -- hearing the board is now meeting on a revised proposal from Blackstone to acquire the company at $70/share, down from $81.50.” The rumor had a tremendous impact on the stock, causing the NYSE to halt trading and ADS to issue a press release that the rumor was false.
In Berliner, there was exceptional evidence: (1) the trader transmitted the rumor through 31 easily documented instant messages; (2) on the same day the rumor was transmitted Blackstone contacted the SEC; (3) the deceit involved the existence of a single board meeting that was easily proven false; (4) the rumor was transmitted in the United States and it involved United States companies so the SEC did not need to expand its investigation internationally; and (5) Berliner covered his short positions in transparent trades after ADS’s stock plummeted. It is implausible that the SEC will strike gold such as the Berliner case often.
The long-term ramifications of the foregoing regulatory measures have yet to be seen. In the interim, firms that come into contact with suspect rumors should examine their policies and procedures in light of the compliance-oriented questions posed in NYSE Regulation’s letter noted above. Whether or not securities regulators ultimately bring a single case premised upon the spreading of false or misleading rumors, the message has been sent that securities regulators will be watching financial firms’ conduct in this area.