Using negative market sentiment for positive gain has become an increasingly prevalent fact of life. As the downturn in the global financial markets gathers pace, the vultures are circling, discovers Lindsey Rogerson.

Consensus thinking is that market abuse is notoriously difficult to prove. But new technology, coupled with tougher powers for regulators and upcoming legislative changes could mean that things are about to change. The gig might finally be up for those who seek to profit from spreading false rumours.

When rumour mongers threatened one of the UK’s biggest financial groups HBOS recently, wiping 20% off its market value in an hour, the Financial Services Authority (FSA) was quick to step in and declare it would hunt down the guilty. Indeed, that HBOS was a target of the rumour mongers marked a new, potentially worrying turn of events.

“Short selling rumours by their nature are best done on weak, or perceived to be weak, companies,” explains Nick Martin of HIM Capital. “In times of fear [like the current credit crunch] these rumours are much more effective so I would expect there to be more than say a few years ago.”

The culprits in the HBOS case have yet to be identified, but many market commentators believe that those who have been quietly profiting from spreading false rumours for years have shot themselves in the foot by targeting such a high profile bank. An HBOS spokesman told Global Reinsurance that it had passed a file on the event to the FSA’s investigators.

Prime suspect

Suspicion has already fallen on hedge funds. These are funds specialising in short selling – where a fund sells a stock at a certain price at a certain date, believing the share price of the company concerned will fall and it will be able to buy it back more cheaply, thus making a profit. They are an obvious target for suspicions.

Certainly when Canadian insurance group, Fairfax Financial, saw its share price fall in 2006, it laid the blame at the door of hedge funds, including SAC Capital Management, Sigma Capital Management, Lone Pine and Exis Capital. It lodged legal action claiming $5bn in damages in Superior Court, Morris County, New Jersey. The action is ongoing.

“When rumour mongers threatened HBOS, the FSA was quick to step in and declare it would hunt down the guilty

However Florence Lombard, chief executive of the Alternative Investment Management Association, believes hedge funds are fast becoming a convenient scapegoat. “Disappointingly, hedge funds are often made the focus of media attention when any suspicions of market irregularities arise. It is vital that the legitimate shorting of assets should not be confused with alleged market abuse by, as yet, unidentified players in the market,” she says.

Only time will tell who is to blame. But there is a real sense that the guilty party may actually be identified in the HBOS case.

What’s changing?

The EU is currently reviewing its Market Abuse Directive, asking for opinions on how the Directive might be updated to better protect investors. Chancellor Alistair Darling is also set to give the FSA US-style plea bargaining powers, which would mean it could grant immunity from prosecution to whistler blowers in exchange for them testifying against colleagues who had engaged in market abuse.

The proposed new powers are just one element of the FSA’s toughened stance against those who seek to profit from spreading lies, all of which bodes well for companies who find themselves the victims of false rumours in the future. The FSA has signed up the software provider Progress Software and the technology consultancy Detica to create a market surveillance system.

The same two companies last month launched a product called Detica Market Surveillance Accelerator, which they say will enable financial institutions and exchanges to monitor trading activity and identify suspicious transactions. This includes market manipulative behaviour such as “front-running”, “painting the tape”, “washing” and “ramping”.

Simon Asplen-Taylor, head of market and regulatory services at Detica, explains: “Market surveillance is all the more challenging due to demands of algorithmic trading and the availability of complex derivatives, cross-border trading and other market factors. The ability to understand what is happening in the market as it happens, and respond quickly enough to pre-empt market abuse, are important factors in building and sustaining market confidence.”

Hunting the guilty down

“Any re/insurers whose shares are manipulated need clear guidelines in order to protect shareholders’ interests

Dan Tench a partner in the litigation & arbitration group at London-based solicitors Olswang also believes that technology can be harnessed to track down the guilty. He points out that most internet activities leave a trace, even when the person sending emails or posting to bulletin boards does their best to cover their tracks. Court orders can be used to get web-hosting companies to hand over the details of where and when an account was opened.

Tench says that the courts can also issue an order for an anonymous emailer to come forward and identify themselves by a certain date. If they fail to comply then they face prosecution (and potentially jail time) for contempt of court.

Despite the tough FSA response, some market watchers are not convinced that the guilty will found, pointing out that pre-paid mobile phones could have been used. However some financial groups are already taking steps to counter such mis-use having banned mobile phones from their trading floors.

Remedies for investors

The Association of British Insurers, which represents the interests of some of the UK’s largest institutional shareholders, said it did not have a policy on what action it expected companies to take. Any insurers or reinsurers whose shares are manipulated need clear guidelines in order to protect shareholders’ interests.

The Financial Service and Markets Act allows for companies and their shareholders to claim damages from a person found to have manipulated their share price. This would mean that should the FSA successfully identify individuals and companies guilty of making false rumours then, in theory at least, it could claims for millions. It could prove financially ruinous not only for the rumour mongers but also any employer deemed to have encouraged their abusive behaviour.

This is because on top of the fine imposed by the FSA – and fines in the past have been in the high six figures – the guilty could also find themselves on the wrong end of a lawsuit from angry investors. Liars beware!

Lindsey Rogerson is a freelance journalist.

Fairfax - Taking hedge funds to task

Fairfax is the most high-profile insurance victim of short-selling rumours to date. The Toronto-based insurer, which owns OdysseyRe and UK-based Riverstone, took action against the hedge funds that were allegedly spreading malicious rumours intended to drive down Fairfax’s share price. One hedge fund representative apparently gained access to Riverstone’s London headquarters by pretending to be a journalist and told staff there that Fairfax was selling Riverstone.
The campaign of harassment – ultimately designed to undermine Fairfax – is said to have included various methods of intimidation, including stalking, threats of imprisonment and pranks to unnerve company executives. According to Fairfax, “They disseminated widely in the market false and defamatory rumours, including, for example, rumours that Fairfax’s CEO Prem Watsa had absconded with stolen company funds and was being pursued by the Royal Canadian Mounted Police.
A $5bn lawsuit is now underway against some of the biggest hedge-fund managers on Wall Street. The defendants include SAC founder Steven Cohen; Rocker Partners founder David Rocker and Exis Capital Management and its chief executive, Andrew Heller. They are accused of “a massive and fraudulent disinformation campaign attacking Fairfax… including the preparation of ostensibly objective, but in fact biased, negative stock analyst reports; defendants’ accumulation of short positions in the stock of those companies – ie bets that the stock prices would decline; and defendants’ subsequent unleashing of the disinformation campaign and biased analyst reports – thus bringing about the sought-after stock price declines.”
The defendants deny any wrongdoing. They say Fairfax, which experienced record results in 2007, achieving earnings in excess of $1bn, is masking its financial problems.