SEC Goes After Shorts: Killing the Messenger

by: Todd Sullivan

The SEC is ridiculous. When it comes to financials like Citi (NYSE:C), Fannie (FNM), Freddie (FRE), Bear Sterns [BSC], Merrill Lynch (MER), Lehman (LEH) and Morgan Stanley (NYSE:MS), the only people telling the truth are the shorts like Ackman, Einhorn, Loeb and Tilson. Why isn't management being investigated? Virtually every public statement they have made in the end has been erroneous and the shorts, who have been right, are being called "rumor mongers". If it is true, is it a rumor?

Is this like Bill Clinton and "it depends on what your definition of "is" is"?

Anyway, read what Loeb has to say about it in his Q2 letter dated 7/25.

During the second quarter of 2008, the market witnessed a significant increase in regulatory activity by the SEC and other government entities. Over the past several weeks, the SEC has served subpoenas on over 50 different hedge funds, seeking
information relating to short sales in Bear Stearns and Lehman Brothers, and the dissemination of rumors about those companies in the market.

This investigation comes at the same time that the SEC has implemented several other measures designed to address short-selling. On July 15, 2008, the SEC instituted a 30-day emergency measure aiming to make the short-selling of certain financial institutions more difficult by requiring all sellers to borrow or enter into a bona fide agreement with the share lender to borrow the securities prior to the short sale.

The SEC also recently announced that it is concerned about the deliberate spreading of false rumors by short-sellers – known as rumor mongering – which some have claimed led to the Bear Stearns implosion. To this end, the SEC announced that its regulators would immediately begin conducting examinations of broker-dealers and investment advisers to determine whether they have sufficient procedures in place to protect against the dissemination of false rumors.

As you may recall, the SEC conducted an audit of Third Point last year after we registered as an investment advisor. During the course of the audit, the examination staff noted that we regularly communicate with portfolio managers at other hedge funds about investment and trading ideas. The SEC later informed us that it had commenced a formal investigation of Third Point primarily relating to these types of communications. Such conversations permit us to test our hypotheses and refine our thinking and, as a result, we believe that participating in give-and-take with other managers is in the best interest of our investors. Our outside counsel has examined this matter thoroughly and assured us that our position is consistent with the securities laws and that we have not violated any law in connection with these communications.

Regulatory matters are certainly playing a significant role in the life of hedge funds as the obligations and demands of the current regulatory environment continue to increase. However, rest assured that we have a strong operational and legal team to assist me in these endeavors, and as a result, all of us on the investment team at Third Point remain completely focused on our investment activities and maximizing returns for our investors.

Full Letter

Does the fact that the companies are able to place the "safe harbor" disclaimers after their filings eliminate them from investigation? Does that magically make whatever they say, when it turns out to be spectacularly wrong, a "mulligan"?

When it was required of companies to place the "investment risks" and safe harbor in the filings, did it become an unintended consequence that management is now able to paint as rosy picture as humanly possible on the business and those statements - making the presumptions they give investors only good for the day they are filed? Have we, in a effort to get "more disclosure" from them, in essence, indemnified management from any legal recourse for their public statements?

Yet, short sellers are not protected from making the same statements, only in an opposing thesis, even if that thesis is ultimately born out as accurate. Are we only protecting optimism, even if it is disingenuous, for lack of a better word while punishing honest pessimism?

Now, it is true that cases have not been brought by the SEC (yet) but, let's be honest, one would be painfully naive to think that SEC investigations of 50 hedge funds would not have a chilling effect on those who might be inclined to short sell. If shorting Lehman is going to bring a SEC investigation and additional legal costs, is it worth it for the small fund? Probably not.

Is the SEC trying to shut down communications between hedge funds? What is a rumor and what is an opinion? Are they issuing subpoenas to execs at Citi, Merrill and Lehman, asking for all the internal communication and communications they have had with each other, so we can ascertain when they knew they would need additional capital and if this contradicts public statements?

Personally, I do not have the stomach to be a short, not in my nature. If you can do it, go for it. The SEC ought to require shorts to disclose their positions, just like longs do. But, they ought not single them out for dissection because we do not like what they say.

Don't kill the messenger because you do not like the news, go after the guys who created the bad news the messenger delivers...

Disclosure ("none" means no position): Long C, none