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Rumor Has It That the Federal Enforcement Authorities Are Interested in What You Have to Say. When Do Rumors Become Criminal?
Securities Law & White Collar Alert
October 2008
Authors: Irwin M. Latner, Steven D. Feldman, Aismara J. Abreu

Pssst…. The New York Attorney General's Office is doing it. So is the Securities and Exchange Commission, and even the FBI. They are all looking into market manipulation through false rumors and short selling, particularly by hedge funds and other large, non-public investors. The danger to you is that if an employee trades on or passes along a rumor, it may run afoul of the rules against market manipulation or insider trading, leaving your company—and yourself—facing scrutiny and possible liability.

With the criminal and regulatory authorities under pressure to hold persons accountable for infractions contributing to the current financial crisis, now is a good time to take steps to make sure you stay out of trouble. Below, we examine the "rumor sweep" and offer practical points on doing business in this environment.

What Is Wrong with a Rumor

We've all heard them, and your company may have even been the subject of a rumor from time to time. While access to information is what Wall Street is all about, the use of false information to manipulate markets is illegal. It can lead to a loss of confidence in the market, which can lead to panic selling, which in turn is further exacerbated by short selling. So the government is acting to deter it.

This year, the SEC brought the first case in its 74-year history for market manipulation through the spreading of false rumors. The SEC charged Paul S. Berliner, a trader, with securities fraud and market manipulation for intentionally disseminating a false rumor concerning the Blackstone Group's acquisition of Alliance Data Systems Corp. ("ADS"). Several months after Blackstone agreed to acquire ADS at $81.75 per share, Berliner disseminated a false rumor that Blackstone was going to acquire ADS at $70 a share, a significantly lower price. ADS stock plummeted 17 percent that day and Berliner profited by short selling and then covering as the price declined. Berliner settled his case with the SEC for, among other things, a $130,000 civil fine and a lifetime bar from the industry.

SEC Chairman Christopher Cox stated that the message of the case was "simple and direct," and that the SEC would "vigorously investigate and prosecute those who manipulate markets with this witch's brew of damaging rumors and short sales." New York Attorney General Andrew Cuomo has also stated that he would investigate whether short sellers have spread rumors in the market in deliberate attempts to drive down share prices.

The Law

While short selling is generally legal, it is illegal to use false rumors to manipulate stock price in order to profit. It is also illegal to agree with others (i.e., conspire) to distribute misinformation to purposely drive down the price of a stock, and then profit from the decline.

Trading on a true rumor, in the form of material, non-public, inside information, in order to profit, is illegal as well. This is simply insider trading—the buying or selling of a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Those liable for insider trading include the person "tipping" such information, and any person knowingly trading on the tipped information (the "tippee"). To constitute material, non-public information, the information must be specific and more private than general rumor. For example, information about the date of a merger announcement and the acquisition price have been deemed more than general market rumors, particularly if it is specific, reliable information received from a credible source.

What You Should Do to Protect Yourself and Your Firm

In this environment, market participants should take steps to ensure that employees are careful not to cross the line when gossiping with Wall Street colleagues about the market. Below are some practical steps you can take to help prevent rumors from resulting in a civil or criminal action against you, your firm or your employees:

  • Ensure that your company has appropriate training for its employees so that employees know the difference between gossiping and breaking the law. The company should educate employees concerning what constitutes insider trading, so they can identify if they are exposed to insider information.

  • Ensure that your employees know that if they are told a rumor, even though they did not create the rumor, they—and the company—may be liable if they know or are reckless in not knowing, that the rumor was false or misleading and they disseminate it and/or trade on it.

  • Send your company's employees a prompt reminder, either in an email or memorandum format, of the prohibition on creating and spreading false information.
     
  • Implement policies and procedures to detect and prevent the intentional dissemination of false information. These procedures may include, among other things, monitoring of e-mail, instant messages, or use of internet message boards. If such a policy is in place, make certain that is it fully implemented and enforced.

  • If you know or have reason to know that a rumor is, directly or indirectly, from an "insider," do not trade on the rumor. Also, do not pass along the rumor. Insider trading may include tipping such information, trading by a tippee, and trading by one who misappropriates the information. If you are unsure whether a certain trade would be considered insider trading, consult with counsel prior to trading.

  • If you are engaged in short selling, you should ensure that your compliance program addresses the new emergency rules regarding the reporting of short sales. Should you require guidance concerning your requirements in this regard, consult with counsel.

  • If you or your company is contacted by any criminal or regulatory authority regarding trading through a subpoena or by an investigator, contact your attorney. Usually, it is in your interest to postpone any conversation or meeting with authorities until after you have had an opportunity to consult with counsel.

What This Means To You

Businesses should not be complacent. Make no mistake about it—both insider trading and illegal marketing manipulation are forms of fraud, and may be subject to criminal prosecution. Therefore, while most hedge funds and other financial institutions are preoccupied trying to survive these severe market conditions, they must address the issues raised by these new circumstances, and proceed with the utmost caution when handling governmental inquiries.

For more information on this issue or other securities matters, please contact:

Steven Feldman at (212) 592-1420 or sfeldman@herrick.com
Irwin Latner at (212) 592-1558 or ilatner@herrick.com

Copyright © 2008 Herrick, Feinstein LLP. The Securities Law & White Collar Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.