The U.S. Securities and Exchange Commission (SEC) has taken unprecedented emergency action to limit short selling of the securities of certain significant financial institutions. In SEC Release No. 58166, dated July 15, 2008, the SEC, by Emergency Order pursuant to Section 12(k)(2) of the Securities Exchange Act of 1934, is curbing the use of “naked” short selling (i.e. selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed) with respect to certain “significant financial institutions,” including Fannie Mae, Freddie Mac, Lehman Brothers, JPMorgan Chase and several others.

The temporary provisions, which commence at midnight (EDT) on July 20 and end at midnight (EDT) on July 29, require anyone effecting a short sale in the securities of the listed financial institutions to borrow or arrange to borrow the securities before making such sale. According to the SEC, the measures are designed to prevent abusive short selling practices surrounding several financial institutions and to maintain fair and orderly securities markets.

In a related announcement, SEC Chairman Christopher Cox announced on July 13 that the SEC and other securities regulators will immediately begin conducting examinations aimed at preventing the intentional spreading of false information intended to manipulate securities prices. The examinations will be conducted by the SEC’s Office of Compliance Inspections and Examinations, as well as the Financial Industry Regulatory Authority and New York Stock Exchange Regulation, Inc.

The SEC has already opened an enforcement investigation examining whether certain individuals and hedge funds have spread false rumors to manipulate shares in at least two financial institutions. The SEC recently subpoenaed more than 50 hedge fund managers seeking trading and communications data related to short selling and options trading in Bear Stearns and Lehman Brothers, among others.

These examinations are part of the SEC’s overall enforcement initiative aimed at controlling and preventing intentional manipulation of securities prices. Specifically, the examinations are intended to augment the SEC’s ongoing investigation into intentional manipulation of securities prices through rumor-mongering and abusive short selling.

The initial investigation appears focused on hedge fund managers. It is important to note that the anti-fraud provisions of the federal securities laws apply to all investment advisers, whether or not they are registered as such with the SEC. The SEC’s examinations will likely focus on whether a fund manager has controls in place that are reasonably designed to prevent the intentional creation or spreading of false information to affect securities prices, as well as other potentially manipulative conduct.

However, having such controls in place is only the first line of defense against claims of market manipulation. More importantly, recent SEC enforcement actions have focused on whether an investment manager actually adhered to its written policies and created an overall atmosphere of compliance with such securities laws. While it is too early to predict how the investigation will proceed, all fund managers should take a moment to review the effectiveness of their compliance programs and to make adjustments if necessary.