Not open and shut

On April 24, 2008, the Securities and Exchange Commission simultaneously filed and settled a civil action against a trader for spreading a false, negative rumor about a company and subsequently profiting by short-selling the company's stock. While the case was settled without the trader either admitting or denying the allegations of the SEC's complaint, the securities laws the SEC claims were violated include those requiring nothing more than a showing of negligence -- a fact that should give the investment community significant pause.

The SEC alleged that Paul S. Berliner, at the time a trader for Schottenfeld Group LLC, disseminated a false rumor concerning a proposed acquisition of Alliance Data Systems Corp. Nearly six months after an agreement was entered into and announced whereby Blackstone Group LP would acquire ADS at a price of $81.75 per share, representing a premium of nearly 30%, Berliner allegedly sent a false and misleading instant message to 31 traders at a number of brokerage firms and hedge funds claiming that a revised deal was being considered at $70 per share.

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The instant message read as follows:

ADS getting pounded -- hearing the board is now meeting on a revised proposal from Blackstone to acquire the company at $70/share, down from $81.50. Blackstone is negotiating a lower price due to weakness in World Financial Network -- part of ADS's Credit Services Unit, as evidence [sic] by awful master trust data this month from the World Financial Network Holdings off-balance sheet credit vehicle.

ADS' stock subsequently plummeted after the media picked up the "story." Within 30 minutes, the share price fell 17%, from approximately $77 to $63.65 per share.

Berliner began short-selling ADS stock at the same time that he sent his instant message. In a period of about six minutes, Berliner allegedly sold short 10,000 shares of ADS stock at prices ranging from $77.21 to $76.47 per share. About two minutes later, Berliner allegedly began profitably covering his short position with the now low-priced ADS stock. The SEC alleged that Berliner made illicit trading profits of $25,509.

As mentioned above, the case was settled the same day it was filed, with Berliner agreeing to: (i) disgorge $26,129 in alleged illicit trading profits and prejudgment interest; (ii) pay a $130,000 civil penalty; (iii) entry of an injunction enjoining him from future violations of the anti-fraud and anti-manipulation provisions of the federal securities laws; and (iv) entry of a Commission Order barring him from association with any broker or dealer. Yet, even though the action was immediately resolved, the violations Berliner was charged with themselves evidence a possibly dangerous precedent for future SEC enforcement actions.

In testifying about the Berliner case before the U.S. Senate Committee on Banking, Housing and Urban Affairs on July 15, then-SEC Chairman Christopher Cox admitted that in "the entirety of its 74-year history ..., the Commission had never brought an enforcement action of this kind." Cox attributed this to "the difficulty in tracing where a false rumor starts, and proving that it was knowingly false ... ." However, this purported burden of proof, as reflected in Cox's testimony, is at odds with a number of the securities claims in fact lodged against Berliner. In its complaint, the SEC alleged that Berliner had violated Sections 17(a)(2) and (3) of the Securities Act of 1933 (among others), which provide that:

It shall be unlawful for any person in the offer or sale of any securities ... by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly --

2. to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or

3. to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

As has been the law since 1980 with the Supreme Court's decision in Aaron v. SEC, the SEC is not required to prove that a statement "was knowingly false" in order to prove its case under Sections 17(a)(2) and (3). Instead, the SEC is only required to demonstrate that the statement was made negligently. The use of Sections 17(a)(2) and (3) in "rumor" cases, notwithstanding the specific, and, as alleged, egregious conduct at issue in Berliner, is troubling. Under these sections, the SEC could maintain an action against a trader who made a mistakenly false statement about a company that he or she believed to be true, a statement that subsequently affected its stock price and in accordance with which the trader acted to his profit. Absent an intent (that is, scienter) requirement, the door is opened for the imposition of liability on those who simply fail to do their homework. Such negligently false statements are both made by investors and, unfortunately, inform their investment decisions on a routine basis. It is at least questionable whether they are the appropriate province of the SEC or the federal securities laws.

Mark A. Berube is a partner in the white-collar and civil fraud defense practice group at Sheppard Mullin Richter & Hampton LLP.

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