SEC Announces “Sweeping Expansion” of Its Investigation of Short Selling by Hedge Funds and Other Market Participants; Will Include Subpoenas and Require Statements Under Oath About Activity/Positions in Financial Services Company Stocks and Credit Default Swaps. NYSE Regulation and FINRA Conduct Parallel Inquiry Through Onsite Visits to Broker-Dealers.
N.Y. Attorney General Cuomo Commences Investigation into Short Selling of Four Financial Firms’ Stocks in Response to Specific Complaints about False Rumors.
Alabama Securities Commission Conducts Investigation into Short Selling and Spreading of False Rumors Concerning Certain Financial Services Companies, with Other States Potentially Following Suit.
On the heels of last week’s emergency order by the Securities and Exchange Commission (“SEC” or “Commission”) banning short selling in securities of certain financial services companies and requiring weekly disclosure of short positions, the Commission has significantly broadened its investigation into the spreading of false rumors and other manipulative practices with respect to financial services companies, and the New York Attorney General has announced the commencement of an investigation based on complaints of false rumors with respect to four financial services companies. The Alabama Securities Commission is also engaged in a broad investigation of similar conduct relating to certain financial services companies based in Alabama. It is possible that other state securities regulators and foreign regulators will commence similar investigations.
SEC’s Expanded Investigation of Rumors and Market Manipulation
For several months, the SEC has been conducting an investigation into alleged market manipulation of the stock of Bear Stearns and Lehman Brothers through the alleged spread of false rumors about those companies following short selling. That investigation has resulted in the issuance of subpoenas to many hedge funds and other institutional investors. Typically, the Commission does not comment publicly concerning ongoing investigations.
Late Friday, September 19, the Commission issued a rare announcement about that investigation, which described a “sweeping expansion” of its scope to include market manipulation of the securities of additional (unnamed) financial services companies and, for the first time, trading activity in credit default swaps relating to those companies’ securities. The Commission further announced that it has approved a formal order of investigation under which hedge fund managers, institutional investors and broker-dealers with significant trading activity in the swaps or securities of financial services companies will be required to disclose their positions under oath and will receive subpoenas requiring the production of additional documents. Personnel associated with those firms may also be called upon to give testimony under oath.
NYSE Regulation/FINRA Inquiry
The Commission also announced that both the New York Stock Exchange Regulation Inc. (“NYSE Regulation”) and the Financial Industry Regulatory Authority (“FINRA”) will conduct “a separate, parallel inquiry” in coordination with the Commission through on-site visits to various broker-dealers. No information has been provided by either the Commission or FINRA with respect to what types of securities or other instruments will be encompassed by the NYSE/FINRA inquiry.
The Commission’s announcement states only that the on-site visits by self-regulatory organization staff will be made “to address concerns about recent short-selling activity.”
N.Y. State AG’s Commencement of Probe into Rumors and Short Selling
On Thursday, September 18, New York State Attorney General Andrew Cuomo announced that his office had commenced a “wide-ranging investigation into short selling in the financial market” focusing upon the securities of Lehman Brothers Holdings Inc., American International Group Inc., Morgan Stanley and Goldman Sachs Group Inc. Attorney General Cuomo stated that the investigation had been initiated as a result of his office having recently received complaints alleging that false rumors had been spread by short sellers. He did not provide any specific information regarding the types of trading instruments or market participants upon which his investigation would focus. With respect to the timing of his investigation, Attorney General Cuomo indicated that it was on a fast track, stating that he expected to have some results in “a matter of weeks.” The Martin Act—which is a New York State statute—gives the N.Y. Attorney General authority to investigate securities law violations that have a nexus with New York.
Investigations by Other States
The Alabama Securities Commission has also instituted an investigation of short selling and the alleged spreading of false rumors concerning securities of certain financial services companies that are based in Alabama. According to press reports, the Alabama Securities Commissioner has tapped former SEC Chairman Harvey Pitt to assist in that investigation. Other state securities regulators may commence investigations as well.
Legal Issues and Considerations
The SEC investigation, as well as the investigations being conducted by New York and Alabama, are based upon the principle that it is a violation of federal and state laws that prohibit fraud and manipulation in connection with securities transactions for a market participant to establish a short position in a company’s securities and then spread unsupported rumors that depress the trading price of the company’s securities, thereby benefiting the short seller. Accordingly, when sharing information about any company that has publicly traded securities, great care must be taken to avoid spreading false information (positive or negative).
Some media reports have characterized the Commission’s expansion of the scope of its investigation to credit default swaps as “unprecedented” and/or have questioned the Commission’s jurisdiction with respect to such instruments. Swap agreements are excluded from the definition of “security” pursuant to Section 2A of the Securities Act of 1933, as amended (“Securities Act”), and Section 3A of the Securities Exchange Act of 1934, as amended (“Exchange Act”). These provisions expressly prohibit the Commission from establishing regulatory requirements or mandating certain types of recordkeeping or periodic reporting with respect to any security-based swap agreement. However, the SEC does have the authority to bring enforcement actions relating to fraud and manipulation with respect to security-based swap agreements pursuant to express provisions in Section 17(a) of the Securities Act and 10(b) of the Exchange Act, which extend those anti-fraud, anti-manipulation provisions to security-based swap agreements, but not with respect to non-security based swap agreements. Thus, a crucial issue for any recipient of a Commission subpoena directed at trading activity in swaps is whether the swaps at issue are “security-based” or “non-security based.”
Section 206B of the Gramm-Leach-Bliley Act (“GLB”) defines a “security-based swap agreement” as a “swap agreement …of which a material term is based on the price, yield, value or volatility of any security or any group or index of securities, or any interest therein.” GLB Section 206C defines a “non-securitybased swap agreement” as “any swap agreement that is not a security-based agreement (as defined in section 206B).” The security/non-security-based distinction is currently the subject of an SEC case in Alabama federal court involving swaps relating to municipal bond interest rates. (See Securities and Exchange Commission v. Langford, et al., CV-08-0761-S (N. D. Ala., filed April 30, 2008). In that case, the Securities Industry and Financial Markets Association (“SIFMA”) has filed a friend of the court brief asserting that the swaps at issue are non-security-based because they are tied to an index of municipal bond interest rates rather than the price or yield of any particular bond and, hence, the Commission lacks jurisdiction over the activities that are the subject of its Complaint. The link to the SIFMA brief (on SIFMA’s website) is: http://www.sifma.org/regulatory/briefs/2008/SECvLangford-8708.pdf.
Finally, one of the SEC’s press releases stated: “Those institutions [from whom disclosure is sought by the Commission] will also be required immediately to secure all of their communications records in anticipation of subpoenas for those records.” Thus, any firm that is contacted by a regulator relating to one of these investigations (whether or not such initial contact includes a subpoena or a formal or informal request for information) must take great care to ensure that all potentially responsive materials immediately are preserved and are exempted from any document-retention policy that might result in the destruction of such information in the ordinary course. Materials that should be preserved include, but are not limited to, all types of electronic communications (internal and external e-mails, instant messages, Bloomberg messages, etc.) and other electronic information (such as spreadsheets, workbooks, models, PowerPoints, etc.), as well as hard copy documents and recorded telephone conversations (regardless of the medium used, such as tape-recorded lines or voicemail systems). Other materials that should be preserved include electronic backup systems, laptops and any onsite or offsite storage of hard-copy documents or electronic information.