Regulatory Crackdown on the Spreading of False Rumors: 10 Preventative Steps to Consider

July 15, 2008

On July 13, 2008, the Securities and Exchange Commission announced that its Office of Compliance Inspections and Examinations, the Financial Industry Regulatory Authority, Inc. ("FINRA"), and New York Stock Exchange Regulation, Inc. will immediately launch coordinated examinations of broker-dealers and investment advisers aimed at preventing the intentional spread of false rumors to manipulate securities prices.[1]  The SEC’s Sunday announcement of its monitoring and investigatory actions is highly unusual, if not unprecedented, and reflects the increased pace of concern about the potential impact of rumors on the stocks of a number of financial services firms, and their possible contribution to the fall of Bear Stearns.

In particular, SEC Chairman Christopher Cox said that these examinations will focus on the supervisory and compliance controls that broker-dealers and investment advisers, including unregistered hedge fund managers, have in place to prevent securities law violations, including market manipulation.  Chairman Cox noted that these examinations are in addition to the SEC’s ongoing "enforcement investigations into alleged intentional manipulation of securities prices through rumor-mongering and abusive short selling."[2]

Among other things, examiners will review whether broker-dealers and investment advisers’ controls are reasonably designed to prevent the intentional creation or spreading of false information intended to affect securities prices, or other potentially manipulative conduct, and to ensure that employees have appropriate training. [3]

Review of the Law

As Chairman Cox said in announcing the SEC’s action charging Paul S. Berliner, a trader formerly associated with Schottenfeld Group LLC, with securities fraud and market manipulation for intentionally spreading false rumors about The Blackstone Group’s acquisition of Alliance Data Systems (ADS) while selling ADS short: "[t]he message of this case is simple and direct. The Commission will vigorously investigate and prosecute those who manipulate markets with this witch’s brew of damaging rumors and short sales."[4]  Accordingly, disseminating a false rumor about a security, particularly when accompanied by profitable trading, can result in actions under Section 17(a) of the Securities Act of 1933 as well as Sections 9(a)(4) and 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder.

In addition, broker-dealers are subject to SRO rules prohibiting spreading false and sensational rumors, including NASD Rule 5120(e)[5] and NYSE Rule 435(5)[6].  More generally, NASD Rule 2110 and NYSE Rule 476 require broker-dealers to refrain from any conduct or activity inconsistent with just and equitable principles of trade.[7]

Even with these laws and rules in place, the SEC determined that these issues are important enough to prompt a Sunday press release announcing its intentions to continue with its enforcement efforts and to begin an examination initiative to look for policies and procedures in this area.

Review of Policies and Other Controls

The examinations will focus particularly on whether these controls “are reasonably designed to prevent the intentional creation or spreading of false information intended to affect securities prices, or other potentially manipulative conduct.”[8]  Clients are encouraged to be proactive and not wait for exam results.  Among other things, clients may wish to:

1.  Review existing compliance policies to make sure they clearly prohibit the initiation and circulation of rumors, and include attribution, if appropriate;

2.  Remind personnel of the firm’s existing policies or, if needed, update policies to make sure such prohibition is clear;

3.  Consider whether all or certain personnel should receive supplementary communications training on oral and written communications.  For example, NYSE Rule Interpretation 435(5)/01 states that the conversations of personnel who service accounts, handle long distance wires, and sit on trading desks must receive the same degree of supervisory oversight as their written communications; 

4.  Train personnel on how to handle the receipt of rumors and other potentially problematic information.  Sensitize personnel to raise their hands and not go it alone;

5.  Although not required by the SEC or SROs, consider the use of rumor lists for names that are the subject of rumors, and use as a spot check for any suspicious trading in proprietary, customer, or employee accounts in names on the list;[9]

6.  Spot check relevant emails, instant messages, chat rooms, bulletin boards, and other communications for suspicious terms.  Review lexicons to determine if additional words or terminology should be included;

7.  Review sales literature, advertisements, radio and television presentations, and seminar presentations to ensure that they are free of statements that are misleading, exaggerated or based on rumor;

8.  Review trading surveillance protocols for inclusion of the securities of issuers who are the subject of rumors to catch potentially manipulative trading through your shop;

9.  Update your written supervisory procedures to reflect any changes made in procedures; and

10.  Keep records of how and when any of these steps are taken.

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[1]  See SEC Press Release 2008-140 (July 13 2008).

[2]  Id.

[3]  NYSE Regulation, Inc.’s sweep letter available at http://www.nyse.com/pdfs/Sweep%20ltr%20(7-14-08).pdf