July 24, 2008 In recent months, a wave of negative rumors and other information regarding some of the most prominent participants in the U.S. financial industry appeared to have fueled stock market volatility. This has not gone unnoticed by Federal regulators. Recently, the SEC took extraordinary measures aimed at reducing market volatility reportedly due to unfounded rumors and certain short-selling. These steps include issuance of an emergency order prohibiting naked shortselling of certain stocks,1 and the launching of a broad investigation into potential manipulation of financial institution stocks through the spreading of baseless, negative rumors.2 The ultimate ability of the SEC to effectively prevent market disruption through these means, however, may be limited and further action may be initiated.

Rumors and Recent Market Volatility

In March, the financial markets were roiled by rumors that Bear Stearns had insufficient capital. Despite the company’s public attempts to calm its investors and counterparties, within days, Bear Stearns’ liquidity evaporated.3 The result was an emergency buyout – ushered and backed by the Federal Reserve. The buyout averted what was feared could have become a domino effect, creating an industry-wide crisis; but it did little to provide long-term stabilization to the U.S. financial markets. The SEC suggested that Bear Stearns’ failure was caused by a loss of confidence that may have been propelled by negative rumors.4 Then, in early July, widely-disseminated, but unsourced, reports claimed that PIMCO was set to stop trading with another major investment bank.5 PIMCO quickly and decisively publicly denied those rumors.6 Still, over five business days from July 8 to July 14, the subject company’s stock dropped almost 45% (down $9.87 per share).

Most recently, rumors that Fannie Mae and Freddie Mac were undercapitalized threatened the stability of not only their individual stocks, but that of the entire mortgage industry generally.7 Repeated assurances from these entities and from the Federal government that capital reserves are adequate helped, but the stocks of both companies suffered heavily.

The SEC Response

In direct response to these market disruptions, the SEC has embarked on an extraordinary effort to curb certain short-selling, to clamp down on harmful, unfounded rumors, and to prevent what it views as potential market manipulation. On Sunday, July 13, the SEC issued a press release announcing an expansion of existing examinations of registered broker-dealers and investment advisers “aimed at the prevention of the intentional spread of false information intended to manipulate securities prices.”8 The announced examinations will be conducted by the Commission’s Office of Compliance Inspections and Examinations, and, together with similar examinations by FINRA and NYSE Regulation, will be designed to cover a broad spectrum of market participants.9

The SEC’s Division of Enforcement has also stepped in, reportedly issuing investigatory subpoenas to some market participants, including hedge funds, investment banks, and broker-dealers.10 Reportedly, the SEC is looking for documentation in connection with short-selling and the possible dissemination of false rumors regarding financial stocks, in a wide-ranging effort to determine the nature of recent short selling and the ultimate source of any unfounded rumors.

In addition, and perhaps most dramatically, the SEC implemented an Emergency Order on July 15, 2008, designed to stop the spread of “false rumors,” “panic selling,” and certain short-selling situations.11 The Emergency Order generally prohibits naked short-selling of certain financial industry stocks, including Fannie Mae and Freddie Mac, among others, until July 29, 2008 (though it is possible that the SEC will extend this date).12 The order is designed to enhance the stability of financial institutions by aiming to “stop unlawful manipulation through ‘naked’ short selling.”13 The SEC simultaneously announced that the Commission would “undertake a rulemaking to address these issues across the entire market.”14

Potential Enforcement Difficulties

Although the steps recently taken by the SEC are unusual, this is not the first time the SEC has considered taking action to, curtail purportedly disruptive short-selling and so called “bear-raids” based on unfounded rumors. In the late 1980’s and early 1990s, in the shadow of bear raids and unfriendly takeovers often premised on a strategy of driving acquisition-target stock prices to new lows, Congress and the SEC explored available options to prevent false rumors and certain short-selling from affecting the U.S. securities markets.15

During Congressional hearings in 1989, the SEC recognized that short-selling may be a legitimate trading technique: “in many cases, short sellers have provided very much a service to the market in properly pricing securities.”16 Still, the Commission Staff who testified gave a broad view of the Commission’s existing authority to police improper short-selling: “[S]hort selling may violate Rule 10b-5 when it forms part of a fraudulent scheme (e.g., to affect the price of a security for the purpose of inducing the purchase or sale of the security by others), or is accompanied by material misrepresentations or omissions of fact.”17 In giving examples of enforcement against short-sellers and those who disseminate false information or rumors about companies whose stock they are shorting, the Commission cited to cases in which misrepresentations were made by broker-dealers or in investment advisory letters to customers or potential customers (i.e., where the defendants at least arguably had a duty to those listening to the false rumors or information they had disseminated),18 or where short selling was part of a series of prohibited stock transactions (e.g., violating registration requirements by executing naked short-sales prior to an IPO).19

The SEC Staff’s testimony in the 1989 Congressional hearings on short-selling does not identify any pure “false rumor” cases – that is, cases premised merely on the knowing dissemination of a materially false statement by a non-regulated entity, or someone unconnected with the issuer or not involved in a market manipulation. However, in a series of cases in the 1990s and in this decade, the Commission charged private individuals who circulated false information about public issuers over the internet, or who failed to disclose their own trading position in securities when making even free recommendations about such securities, as having committed “fraud” within Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.20 The defendants in such cases were not charged as “investment advisers” or as brokers dealing with customers, both of whom would have a duty to be truthful with “clients.” The individuals also were not alleged to have any connection with the subject companies or their shareholders. Thus, these cases imply that in the SEC’s view, an ordinary, unregulated person who publicly gives even free advice, espouses purported opinions, or otherwise disseminates information even to strangers, has a duty to be truthful. This theory is not free from doubt under the Federal securities laws.

The SEC can indeed bring actions for “fraud” under Rule 10b-5 against anyone making materially false or misleading statements in connection with the purchase or sale of a security. 21 However, this concept has not been expanded clearly by the courts beyond situations in which there is either a direct representation to a party on the other side of the trade, or some duty to specific shareholders, customers or the person with whom the person making the representation is dealing or expects will rely on the statements (whether or not the defendant is registered as a broker-dealer or investment adviser). Nevertheless, in the current environment, the SEC no doubt will apply the reasoning it used in its internet cases against unregulated market participants who knowingly spread false rumors, regardless of the lack of any specific relationship to the issuers, investors or other market participants.

Notably, since the Congressional hearings on short-selling in 1989, the SEC has brought at least three cases that alleged violations of Section 10(b) and Rule 10b-5 where individuals spread to the general public or others with whom they had no relationship, materially false negative information about an issuer with whom they were not associated, and from whom they received no compensation.22 In two of those cases, there was not even an allegation that the defendant profited from the dissemination of the false information.23 In one of the cases, an individual who did not trade in anticipation of or after he disseminated false information in an internet “message board” was convicted of a criminal violation of Rule 10b-5, and consented to an injunction in a civil action brought by the SEC.24

Advancing a theory of market manipulation against those spreading false rumors provides another, potentially broad enforcement option. Section 10(b) of the Exchange Act specifically prohibits “in connection with the purchase or sale of any security” the use of “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” The Supreme Court has referred to market manipulation in broad terms, seemingly making no limitations based on duties or direct dealing. The Court views manipulation as a “term of art when used in connection with securities markets”25 that “prohibits the full range of ingenious devices that might be used to manipulate securities prices.”26 Still, it is unclear how one distinguishes between legitimate short-selling and that which “artificially” affects the market price of a security, and whether the spreading of false rumors can itself be the “device” through which a market manipulation is effected, or whether some improper market transaction is required.

Regardless of the legal theory potentially employed, the heavy practical burden of unearthing actionable evidence against identifiable defendants may impede SEC enforcement efforts to police the spread of false rumors in the securities markets. Indeed, the Commission informed Congress during the 1989 hearings that even where there was evidence of demonstrably false rumors in the market, it was extremely difficult to bring enforcement cases because “neither [the SEC], nor the companies, nor the self-regulatory organizations are able to identify the source of these rumors.”27 This result is perhaps not surprising. Those who start a rumor may not be the same as those who publish it generally to the market; and it is likely hard to prove that those who published it – and those who initiated it – believed it to be false. These hurdles must again be addressed in the SEC’s recent focus on rumors and short-selling, and the applicable legal theories are not without complications and limitations.

Despite the potential difficulties in proof and legal theory, the Commission likely will continue to investigate vigorously any situation where there is the perception that false rumors were spread in connection with short selling that materially affected the price of securities.

Other Possible SEC Actions

Beyond strict enforcement policy, the SEC may also consider implementing additional trading rules designed to parry the impact of false rumors and bear raids. Like the Emergency Order restricting naked short selling, the SEC may consider the reinstallation of the short selling uptick rule, Rule 10a-1 under the Exchange Act. Consideration of a renewed Rule 10a-1 may be, in whole or in part, the additional rule making alluded to in the SEC’s press release announcing the emergency order. That rule, designed to preclude short-selling in a downward trending market, required that every short sale be transacted at a price higher than the price of the previous trade (or equal to the prior trade if that prior trade was made on a plus tick). The rule, originally implemented in 1938, was rescinded in July 2007.

Despite the uncertainty of enforcement theories and the difficulty of gathering proof in false rumor cases, one thing is for certain – as long as severe market instability continues, the SEC will be looking for a solution. The SEC no doubt will aggressively investigate allegations of false rumors and pursue broad theories of liability against those who may knowingly spread such rumors to affect the market price of registered securities.