For months, the trading community has been rife with speculation that the illegal dissemination of false information, so easy to accomplish via the Internet, has played a role in the disastrous slide of financial services stocks. These suspicions had seemingly gone unnoticed by regulators, but that appears to have changed.

An order announced Tuesday by the Securities and Exchange Commission chairman, Christopher Cox, requires short sellers to pre-borrow shares needed to replace those sold short. By law, short sellers are required to locate shares in advance of their sales, but they have not in the past been forced to actually borrow the shares ahead of time. A spokesman for the SEC, John Nester, suggests that the new rule will enforce a requirement that in the past has been “hard to nail down” and often violated.

In fact, from conversations with officials at the SEC, the New York Stock Exchange, and the Depository Trust and Clearing Corporation, I would say it appears that no one has been monitoring whether short sellers are complying with the law by locating stocks with which to cover their sales.

The practice of “naked shorting” can only be seen when a firm fails to deliver the stock that is due to the buyer. Interestingly, only broker-dealers actually report “fails,” not investors. A spokesman for the NYSE said that, most often, if a hedge fund fails to deliver a stock that it has sold short, its prime broker goes into the market and covers the trade. If the prime broker covers, then there is no fail.

We should note that there are many reasons why a seller might fail to deliver stock. The most common is that the seller could not locate stock that is being heavily shorted. Failures to deliver stock are reported to Financial Industry Regulatory Authority, and that organization relays it back to the stock exchanges. The exchanges list stocks for which failures to deliver meet a threshold of more than half of 1% of the total outstanding shares. Interestingly, only Deutsche Bank (DB $84.60) is on both the list of stocks to require pre-borrowed shares and on the July 15 NYSE list. FINRA’s Brendan Intindola points out that companies with large market caps are less likely to appear on the list because of the threshold requirements.

This is a technical issue, but the point is that without the pre-borrowing requirement, the authorities appear to have had shockingly little notion in the past of whether investors are complying with the rules against naked short selling. Deutsche Bank may be the only SEC-designated name on the NYSE list of companies that have experienced large failures to deliver, but numerous other financial services companies are posted. For instance, stocks that have a high fail rate (and are therefore probably victims of heavy naked short selling) include Colonial Bancorp (CNB $4.45), which is off 85% over the past year but was up 20% yesterday; First Federal Financial (FED $5.34), off 92% over the past year but up 15% yesterday, and National City Corporation (NCC $4.20), off 89% over the past 52 weeks but ahead 17% yesterday. Did the outlook for bank stocks really improve yesterday, or did Mr. Cox’s new ruling rein in illegal behavior? Let’s hope both are true, but I haven’t seen any great change in the credit markets that would turn the banks so abruptly.

Many market analysts have been concerned not only with naked short selling, but with the lack of any restraint on the practice. A partner at powerhouse legal firm Wachtel Lipton Rosen & Katz, Edward Herlihy, put out a note to clients July 1 saying, “Short sales are at record levels and there are suggestions that false rumors about the demise of firms and bear raids are taking place.” He is among those critical of the SEC’s decision to scrap the uptick rule.

The rule, which specified that short sales could be made only when a stock moved higher, was originally imposed in 1938 to restrain short selling in a down market. “Our view was that the SEC should reimpose the rule for 120 days to dampen volatility,” Mr. Herlihy said. He said Tuesday’s action by the SEC “does not go far enough.”

The chairman of the SEC, Christopher Cox, startled Wall Street on Tuesday by announcing an emergency order aimed at curbing illegal naked short selling. That wasn’t his only surprise. Testifying before the Senate Committee on Banking, Housing and Urban Affairs, he also made it clear that the SEC is clamping down on rumor mongering, long the tool of short sellers and the bane of investors and managements. For the first time in the agency’s 74 year history it recently brought a successful suit against a trader that spread false information via text messages about a pending acquisition. The trader caused the stock to fall by 17% and wiped out $1 billion of market cap in 30 minutes, Mr. Cox said. His comments followed on the heels of an announcement July 13 that the agency would be conducting examinations of broker-dealers and investment advisers “aimed at the prevention on the intentional spread of false information intended to manipulate stock prices.”

Perhaps not coincidentally, news circulated yesterday that Goldman Sachs’ CEO Lloyd Blankfein has been questioned by the managements of Bear Stearns and Lehman about whether his firm spread damaging and untrue information about those firms, leading to the cataclysmic decline in their stocks.

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