Federal regulators are cracking down on the potential spread of false and misleading rumors that could potentially affect market conditions.

While rumor mongering is not a widespread problem in the financial industry, a few high-profile cases-the SEC investigating 50 hedge funds last week for potentially spreading rumors on the fall of Bear Stearns and Lehman, and halting shorting Freddie Mac and Fannie Mae-have forced regulators to take a strong public stance against such actions. Then there were the arrests last month of former Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin for securities fraud and the April settlement of securities fraud and market manipulation charges by Paul Berliner, a former trader with the Schottenfeld Group.

"Those who commit fraud at the expense of investors will always be the target of a relentless SEC," said Securities and Exchange Commission Chairman Christopher Cox last week during testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs.

"Because the reliability of information about public companies in the marketplace is so important to market confidence, there have long been clear rules in place that prohibit market manipulation by knowingly spreading false rumors," Cox said.

Officials at the SEC, the Financial Industry Regulatory Authority (FINRA) and NYSE Regulation are teaming up to enforce these existing regulations, which include SEC Rule 10b-5, NASD Rule 5120(e) and NYSE Rule 435(5).

Last Monday, NYSE Regulation and FINRA sent letters to as many as 20 broker/dealers asking for copies of firm policies and procedures pertaining to the monitoring and control of the spread of false and misleading rumors. The letters request a description of how the firms monitor electronic communication from cell phones, Blackberrys and other computers-including external and internal e-mails, instant messages, chat room and message board activity-and if they have software to search for specific subjects, topics and names.

The letters ask if the firm has conducted any reviews or investigations of false or misleading rumors since January, specifically regarding the impact of the subprime loan business on certain financial institutions, the use of the Federal Reserve's discount window and/or the possible federal bailout of financial institutions.

Furthermore, the letters ask for a description of the outcome of any such review, including the findings, any internal discipline or similar actions. Firms that received the letters have until July 28 to comply.

A copy of the letter can be found on FINRA's and NYSE Regulation's websites.

"We want to be absolutely clear what the focus of the letter is," John Malitzis, executive vice president for NYSE Regulation's market surveillance division, told MME. "Our focus is not on the legitimate flow of information on the part of traders. We don't want to squelch the normal dialogue between brokers and their customers. We are concerned about people spreading false or misleading rumors. Our goal is not to be the information police."

Controlling the spread of rumors is an issue that firms take very seriously. It is illegal to spread false or misleading rumors that can affect market conditions, and many firms, investment advisors, mutual funds and hedge funds have software programs in place that leave a digital paper trail, allowing them to monitor and detect such activity.

The firms and regulators can use these clues to track the date and time of a trade and also the computer or device from which the trade was made.

In late November 2007, Berliner fabricated a rumor that The Blackstone Group had renegotiated the purchase of Alliance Data Systems Corp. for a lower price. Using instant messages, he spread the false rumors to numerous traders at brokerage firms and hedge funds, and within 30 minutes, Alliance's stock plummeted.

According to the SEC, Berliner profited from the drop by short-selling Alliance before the NYSE temporarily halted trading of the stock. The stock recovered to its original price by the end of the day, but the damage was done.

A few months later, Blackstone and Alliance canceled their merger, causing Alliance stock to drop further.

The SEC is currently focusing on the March collapse of Bear Stearns and those who profited from its demise. The FBI arrested former Bear hedge fund managers Cioffi and Tannin last month for securities fraud after the two failed to inform investors of a precipitous decline in the subprime market last spring. The two are alleged to have continued to tout their funds' resilience to investors while pulling millions of dollars of their own money from the funds.

Days before Bear's collapse in mid-March, a number of hedge funds placed short positions on the stock, sending Bear into a freefall that ended with the investment bank being purchased at a fire-sale price by JPMorgan Chase. Those hedge funds-Greenlight Capital, Harbinger Capital Partners, Paulson Investment Co. and Tremblant Capital Group-reaped huge profits by shorting Bear.

John Paulson, a former managing director at Bear and founder of the hedge fund Paulson & Co., has made staggering profits in recent years by betting against subprime mortgages and the financial products that hold them. Paulson made an estimated $3.7 billion in 2007.

"We have been very actively investigating for some months people deliberately spreading false or misleading rumors while trading," SEC spokesman John Nester told MME. "This is potentially a problem; we are trying to eliminate the potential." Nester said this is a wide-ranging investigation, and declined to comment on specifics.

While false rumors may or may not have been a factor in Bear's collapse, regulators are tightening the noose and more arrests may be in store.

(c) 2008 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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