The manipulation of securities prices has been illegal under federal securities law for more than 70 years. Surprisingly, however, the Securities and Exchange Commission had never brought an enforcement action alleging market manipulation through the intentional spreading of false rumors until this past April.
That’s when the SEC filed a settled case against Paul Berliner, a trader who had formerly been associated with Schottenfeld Group. The SEC alleged that last November, Berliner profited by selling short while intentionally spreading false rumors through instant messages to numerous people, including traders at brokerage firms and hedge funds, about Blackstone Group’s acquisition of Alliance Data Systems. In the SEC’s announcement of the case—which came just a few weeks after allegedly false rumors of liquidity problems supposedly helped to torpedo Bear Stearns—SEC Chairman Christopher Cox offered a statement that the message of the case was simple: The SEC would “vigorously investigate and prosecute those who manipulate markets with this witch’s brew of damaging rumors and short sales.”
The SEC’s case against Berliner did generate some buzz among securities enforcement lawyers, but apparently Cox’s message was lost on many short sellers, who reportedly turned their sights on Lehman Brothers at the end of June. At that time, false rumors began to fly that Lehman was about to be acquired by Barclays for the paltry sum of $15 per share, less than its market value. Another reported rumor on July 10, subsequently picked up by CNBC, was that two of Lehman’s major clients had stopped doing business with the firm. This rumor knocked nearly 20 percent off Lehman’s price before it was disproved later in the day and the stock price rebounded.
Pressure from Wall Street to do something in response to the type of rumors that plagued Bear Stearns and Lehman Brothers, as well as additional rumors then swirling about the future of Fannie Mae and Freddie Mac, finally drove the SEC to issue a special statement on July 13, 2008. Issued on a Sunday night before the markets opened in Asia as an apparent warning to broker-dealers, hedge funds, and others who might spread rumors, the SEC announced that its Office of Compliance Inspections and Examinations, as well as the Financial Industry Regulatory Authority and New York Stock Exchange Regulation, would immediately conduct examinations “aimed at the prevention of the intentional spread of false information intended to manipulate securities prices.”
The examinations would focus on the extent to which broker-dealers and investment advisers were meeting the requirements that they have supervisory and compliance controls to prevent market manipulation, and specifically whether such controls were reasonably designed to prevent the intentional creation or spreading of false information intended to affect securities prices. In other words, the regulators are looking to make sure your rumor control is up to par. The SEC added that the examinations by OCIE would be in addition to any investigations by its Enforcement Division into “alleged intentional manipulation of securities prices through rumor-mongering and abusive short selling” that were already underway.
Within days, it was reported that the Enforcement Division had indeed issued subpoenas to many of Wall Street’s largest investment banks, such as Goldman Sachs, Deutsche Bank, and Merrill Lynch, seeking trading records, e-mails, and other information related to possible manipulation of Lehman Brothers and Bear Stearns securities. In addition, more than 50 hedge funds also received subpoenas seeking similar information concerning Lehman and Bear Stearns, specifically including the rumor about Barclays, the rumors of two major clients supposedly pulling their business, and another rumor (denied by Lehman) that Lehman had been forced to go to the Federal Reserve’s special broker-dealer discount window to borrow money to preserve liquidity.
What is it, specifically, that the SEC is trying to achieve here? And what are the likely outcome and ramifications?
According to the Wall Street Journal, the SEC plans to use the information it has demanded in the subpoenas—e-mails, transcripts of telephone calls, messages, and more—to attempt to trace the allegedly false rumors all the way back to their original source. In Congressional testimony on July 15, Chairman Cox stated that the SEC’s inability over the past 74 years to bring a case alleging false rumors “was probably because of the difficulty in tracing where a false rumor starts, and proving that it was knowingly false … But now the same technology that instantly spreads market rumors across the globe is also helping law enforcement track down the culprits.”
The filing of the Berliner case provides at least some support for the chairman’s optimism, but the fact remains that the SEC has no systematic way to parse through the rumors, partial information, speculation, gossip, and educated guesses that are all a fundamental part of the millions of trading decisions and discussions that occur each day around the world. Indeed, many of the technologies used today and tomorrow to spread information between traders are not, and likely will not be, traceable by the SEC (such as unrecorded calls on private cell phones, certain types of text or instant messages, and so forth).
Moreover, in the unlikely event that the SEC can chase down these rumors (“tracking down smoke,” as one commentator colorfully described it) and somehow find a document trail leading back to the original source, it will also need to prove that any false information was spread intentionally—that is, that the person actually knew that the information was untrue. Given these daunting obstacles to success, it seems unlikely that the SEC’s enforcement effort will net more than a tiny number of rumor mongering traders at most.
There may be negative side effects from the SEC’s effort, as well. The SEC’s target—short sellers—serve an important role in that they help to stabilize markets that have become too frothy. As stated by Peter Wallison, the former general counsel of the Treasury Department: “The only real protection against these [financial] bubbles is a bunch of people who believe the opposite.” It’s common practice and completely legal today, for example, for a hedge fund manager who has sold a stock short because he believes the company’s accounting is suspicious to spread the information he has about that company aggressively. With the SEC’s crackdown on rumors comes the risk that the SEC’s subpoenas and saber-rattling will cause short sellers to stop sharing even legitimate negative news or opinions for fear that the SEC might pursue them for spreading false rumors. Indeed, there are already reports from financial journalists that some short sellers, who are typically an invaluable source of information and contrary perspectives on companies, are now unwilling to offer any comments.
The SEC should know the likelihood of success and the costs and benefits of its campaign against false rumors as well as anyone, and has presumably concluded that even if it cannot track down much “smoke” it will still accomplish something important. The SEC likely believes that the combination of the statements by Chairman Cox, the high-profile investigations by the Enforcement Division, the subpoenas issued to scores of leading hedge funds and investment banks, the OCIE examinations, and perhaps the recent example made of Berliner in April 2008 will at least deter some market manipulation that has not yet occurred—and that this result is worth the cost of pursuing it.
Either that or, as one commentator recently observed, “It’s a bit like the high priests doing a rain dance in a drought. It doesn’t matter whether it makes sense. They just need to be seen doing something.”