Issue of the week: The SEC hunts rumormongers

Psst—did you hear that the Securities and Exchange Commission is cracking down on rumors? asked Stephanie Clifford and Jenny Anderson in The New York Times. It’s true—SEC Chairman Christopher Cox said this week that the market-regulating agency would begin examining “rumor-spreading intended to manipulate securities prices.” It’s not illegal to pass along company scuttlebutt, of course. But it is a crime to knowingly spread false information, and someone has been spreading unfounded stories that investment bank Lehman Brothers is about to be taken over. Lehman CEO Richard Fuld has been demanding that the SEC act to quell the rumormongering, adding to the calls for action Wall Street has been making since March, when investment bank Bear Stearns collapsed amid rumors that it was running out of money.

The Bear Stearns case certainly deserves a thorough investigation, said Bryan Burrough in Vanity Fair. The venerable investment bank may have been done in “not by a criminal indictment or a mammoth quarterly loss but by rumor and innuendo that, as best one can tell, had no basis in fact.” Former Bear executives suspect that rival investment bank Goldman Sachs and two hedge funds, Citadel Capital Management and SAC Capital Partners, were behind the rumors. All three stood to gain from Bear’s fall—Goldman would be rid of a formidable competitor, while Citadel and SAC would profit from bets that Bear stock would tumble. Goldman, Citadel, and SAC deny any involvement in rumormongering, but many on Wall Street continue to believe that someone struck it rich by spreading scare stories about Bear’s finances. “If I had to pick the biggest financial crime ever perpetrated,” said an unnamed investment banker, “I would say, ‘Bear Stearns.’”

But the funny thing about all these rumors, said Barry Ritholtz in the finance blog TheBigPicture.com, is that they tend to vex companies that could stand a little critical scrutiny. Whether the firm in question is Bear Stearns, Lehman, or, this week, Fannie Mae, the rumormongers are apt to attack the most “overleveraged, undercapitalized, poorly managed companies.” Nobody ever seems to go after “the firms with strong balance sheets, good business models,” and solid profits. So maybe those nasty rumors serve a healthy purpose.

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That’s why any SEC crackdown on rumors could be counterproductive, said John Carney in the financial website Dealbreaker.com. Some investment bankers and Wall Street analysts want the SEC to use its subpoena power to get to the bottom of rumors. But that would only “make markets less efficient.” Investing boils down to a search for the truth about a company’s financial condition and prospects, and rumors are part of that process. “If subpoenas start flying around,” it could have “a chilling effect on the way information gets passed around Wall Street.” Are we going to start hauling people into court for comparing notes with colleagues? “Your right to express your doubts about the financial health of a company” would suddenly be a matter for the courts. It sounds to me that the cure for rumors is worse than the disease.