PLI: How did federal regulators react to charges that, in part, short
selling drove the financial collapse toward the end of 2008?
AUDREY STRAUSS: Naked short selling and false rumors are frequently cited as having caused or hastened the collapse of several major financial institutions in 2008.
Although speculation that naked short selling and rumors
contributed to the collapse of several major financial institutions,
including Lehman Brothers and Bear Stearns, was never conclusively
resolved, it did provide impetus for the government to take action to
curb the spread of false rumors and impose stricter regulations on
Initiatives by Regulators: On July 13, 2008, the SEC announced that, in conjunction with FINRA and the New York Stock Exchange, it was going to begin examining the adequacy of internal controls to prevent "the intentional creation of false information intended to affect securities prices, or other potentially manipulative conduct."1 As part of this investigation, FINRA and the market surveillance division of NYSE Regulation requested from multiple broker-dealers information pertaining to the internal monitoring of false rumors, including:
In July 2008, the SEC issued subpoenas to dozens of hedge funds and
investment banks requesting information pertaining to the short selling
of the stock of financial issuers, and rumors circulated prior to the
collapse of those issuers. The subpoenas requested documents concerning
multiple forms of communication — including transcripts of recorded
phone calls, e-mails, and instant messages — evidencing an interest in
tracking down the origins and paths of certain rumors.3
In July 2008, citing reasoning that "[f]alse rumors can lead to a loss of confidence in our markets [and to] . . . panic selling" — the SEC issued an emergency interim order pursuant to Section 12(k)(2) of the Exchange Act requiring all persons seeking to effect short sales for the stock of nineteen financial issuers to borrow or arrange to borrow the securities of the issuer.4 In September 2008, the list of restricted issuers was expanded to include over 500 financial institutions.5 In July 2009, the SEC finalized its short selling rules. Among other things, the rules require physical settlement of a short sale within four days and that the short seller borrow or arrange to borrow the issuer's shares.6
In August 2009, the SEC brought and settled its first enforcement actions for violations of the new short selling rules.7
In April and August 2009, the SEC began soliciting public comment on several other proposed rules governing short selling, including the imposition of circuit breakers that would allow a ban or restriction of short selling a stock for the remainder of a day following a significant decline in the price of that stock.8
SEC Enforcement Actions: To date, no enforcement actions have been brought as a result of the 2008 investigations into the dissemination of false rumors. The only action based entirely on the dissemination of a false rumor, SEC v. Berliner, discussed below, was filed and settled in April 2008, months before the SEC announced its multi-agency investigation. The absence of other enforcement actions to date may well be due to the difficulties that regulators face in making these cases: it is hard to trace the origin of the false rumors; even if traced, it may be difficult to prove the falsity of the rumor and that the disseminator knew it was false.
SEC v. Berliner: In April 2008, the SEC alleged that trader Paul Berliner violated Section 17(a) of the Securities Act and Sections 9(a) and 10(b) (and Rule 10b-5 thereunder) of the Exchange Act, when he disseminated an allegedly false rumor concerning the Blackstone Group's acquisition of Alliance Data Systems Corporation ("ADS") that caused the price of ADS stock to plummet and allowed Berliner, who had short sold ADS stock, to profit. Complaint, SEC v. Berliner, No. 08-CV-3859 (S.D.N.Y. Apr. 24, 2008).
In May 2007, Blackstone announced that it had entered into a definitive agreement to acquire ADS at $81.75 per share. According to the SEC's complaint, months later, on November 29, 2007, Berliner wrote an instant message to 31 securities professionals stating that Blackstone was negotiating a lower price for ADS due to problems at ADS — "ADS getting pounded — hearing the board is now meeting on a revised proposal from Blackstone to acquire the company at $70/share . . . Blackstone is negotiating a lower price due to weakness in World Financial Network — part of ADS' Credit Services unit." Id. at 3-4.
Berliner's statements were disseminated far beyond his 31 instant message recipients — the rumor was picked up and reported on as a potential fact by the media. Id. at 4.
According to the SEC, at the same time that that Berliner sent messages concerning ADS, he short sold 10,000 shares of ADS. Prior to the short sale Berliner did not have or arrange to borrow ADS shares to cover his short position (causing him to hold what is commonly known as a "naked short" position in ADS). When the price of ADS began to plummet, Berliner covered his short positions in ADS, resulting in $25,509 in profit. Id. at 4-5.
Within 30 minutes after Berliner's first instant message, the share price of ADS declined by 17%. The New York Stock Exchange temporarily halted trading in ADS and ADS issued a corrective public statement, following which ADS's share price returned to approximately the same price at which it traded prior to Berliner's messages. Id. at 5.
Berliner settled with the SEC in April 2008 for $130,000, disgorgement of all profits and a lifetime industry bar.9
Future Enforcement Actions: In discussing potential future enforcement actions, SEC staff have stated that they are focused primarily on the falsity of information and knowledge of falsity.10
The Berliner case was fairly straightforward — the rumor at issue was demonstrably false, the rumor was almost certainly originated by Berliner, the rumor caused an immediate and precipitous drop in stock price, and Berliner made numerous trades, from which he ultimately profited, at the same time that he disseminated the rumor.
Cases involving rumors, particularly those concerning more subjective and less easily provable falsehoods (e.g., the inadequacy of capital reserves), about most financial issuers are harder to prove.
Of additional concern is the possible liability of securities professionals who disseminate but do not originate information that is ultimately determined to be a false rumor or of securities professionals who use or rely on rumors (that may, on their own, be considered immaterial) when making recommendations or reports disseminated publicly or to clients.
Regulating False Rumors Without Chilling Legitimate Communications: In addition to the difficulties inherent in charging and proving a false rumor case, there is an inherent tension between the free and unfettered flow of information and regulatory efforts to restrict the dissemination of rumors, which are, at their most basic level, information.
Restricting speech, including rumors, raises First Amendment concerns: First Amendment challenges to SEC enforcement actions alleging the publication of misstatements have been raised, but not resolved. See Lowe v. SEC, 472 U.S. 181 (1985) (declining to address a First Amendment challenge to the Investment Advisors Act of 1940 under the principle of constitutional avoidance); see also SEC v. Siebel, 384 F. Supp. 2d 694, 709 n.16 (S.D.N.Y. 2008) (declining to address a First Amendment challenge to Regulation FD).
In Lowe v. SEC, 472 U.S. 181 (1985), the Supreme Court granted certiorari to decide the constitutional question of whether a corporation violated the Investment Advisors Act of 1940 by publishing investment advice after being barred from serving as an investment adviser. The corporation's First Amendment right to publish financial advice was raised as an issue before the district and appellate courts, but the Supreme Court resolved the case on other grounds, declining to reach the First Amendment issue. Id. at 185-86, 190, 211.
Concurring in the result, but not the legal argument, Justice White argued that restrictions on commercial speech must be narrowly tailored to serve a legitimate government interest and that the "drastic prohibitions" on speech in Lowe — prohibiting the corporation from publishing any financial advice — could not be justified by the mere possibility that the speech might be fraudulent. Id. at 234-35.
Justice White drew a distinction between government regulation of a profession (even if regulation happens to impact speech) and regulation of individuals not acting in the professional capacity contemplated by Congress. Justice White sought to "locate the point where regulation of a profession leaves off and prohibitions on speech begin" and stated that "[w]here the personal nexus between professional and client does not exist, and a speaker does not purport to be exercising judgment on behalf of any particular individual with whose circumstances he is directly acquainted, government regulation ceases to function as legitimate regulation of professional practice with only incidental impact on speech; it becomes regulation of speaking or publishing as such, subject to the First Amendment's command that 'Congress shall make no law...abridging the freedom of speech, or of the press.'" Id. at 262.
Justice White concluded that the Investment Advisors Act could not be applied as an automatic restraint on the publication of impersonal investment advice. Id. at 236.
Drawing on Justice White's concurrence in Lowe, in Taucher v. Born, 53 F. Supp. 2d 464 (D.D.C. 1999), the district court held that Section 4m of the Commodity Exchange Act ("CEA"), which made it unlawful for a commodity trading advisor to publish and sell information about futures trading without registering with the CFTC, was an unlawful prior restraint on speech in violation of the First Amendment. Id. at 482.
In addition to potential First Amendment issues, there is no clear line between regulation of deceptive speech and regulation of speech that conveys information for legitimate corporate purposes (even if the information may ultimately be determined to be inaccurate). At a broader level, there is an inherent tension between the free and unfettered flow of information and regulatory efforts seeking to restrict the dissemination of rumors.
Imposing individual liability on securities professionals who disseminate rumors will almost certainly chill the exchange of information.
counsel face major challenges in responding to the SEC's enforcement
actions relating to the dissemination of rumors: ensuring that
companies have adequate policies and programs to monitor and
appropriately restrict the intentional dissemination of false
information (which is known to be false) in connection with securities
transactions, while at the same time ensuring that such policies do not
unnecessarily infringe upon the free flow of information necessary for
securities and market professionals to conduct legitimate business
At a minimum, any policy should restrict the knowing dissemination of false rumors in connection with the purchase or sale of securities or with the intent to affect price.
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