Senior Fellow Kevin A. Hassett

Suppose you caught wind that a preposterous story was spreading around town that you are a drug user. What would you do?

Your first thought might be to take out an advertisement in the newspaper announcing that you are clean. The downside of that approach is you would broadcast the false rumor to everyone and presumably raise as many suspicions as you quell.

A preferable alternative would be to call up a few influential people and show them drug tests proving your innocence, then trust that they would quietly spread the word.

Now imagine you live in a world where the government has made it illegal to defend yourself in private conversations. You're allowed to take out an advertisement yet not to make phone calls. In that world, presumably, many more false rumors would have a life of their own, since the law has made it so costly and difficult to defend yourself.

What does this little thought experiment have to do with current events? Everything. A little-appreciated footnote to the Bear Stearns Cos. story may well be the headline in the history books. As rumors spread and induced a panic, Bear Stearns executives were, judging from the law at least, constrained in the types of communications they could have with customers.

Call the Boss

In the old days, if you were a big customer and heard speculation that a firm such as Bear was in trouble, you might call up the boss and ask him about it. If the rumor was that the firm was flat broke, then he might invite you to his office and show you his list of assets to calm you down.

Alternatively, if a chief executive received a number of troubling phone calls, he might summon a highly respected analyst to his office and open up his filing cabinets. If things checked out, the analyst would then issue a report saying that the bad rumors were unfounded. If he tried to get cute and profit personally from the opportunity, then insider-trading laws would apply.

Such a common-sense response to false rumors is now a crime. The law makes innuendo-based attacks far too easy.

Regulation Fair Disclosure, or Reg FD, was developed under the leadership of former Securities and Exchange Commission Chairman Arthur Levitt and went into effect in October 2000.

"Selective Disclosure"

Levitt's intention was to stop the "selective disclosure" of material or market-moving information to certain analysts or investors. The SEC feared that the head-start gave these people an unfair advantage, allowing them to "make a profit or a loss at the expense of those who were kept in the dark."

Reg FD mandates that any material information given to these high-profile insiders be simultaneously released to the public. Levitt is a director of Bloomberg LP, the parent of Bloomberg News.

The rule has had a chilling effect on company disclosures. It took a while, but it seems that the market response to this dramatic regulatory change is becoming evident. Short sellers, individuals who make bets that a stock's price will drop, can make their transactions and then spread damaging rumors about the company.

The company will, because of Reg FD, have an extraordinarily complicated time responding while adhering to the law. While the truth may well seep out over time, if the short sellers can panic customers and the liquidity of the target can be soaked up by a short-term run, then the strategy might work before the truth can come out.

Bear's Scenario?

One could forgive some at Bear Stearns for feeling that this scenario illustrates what happened to them.

While the Federal Reserve has adopted a number of policies to make such a liquidity crisis less likely, the fundamental mismatch between rumor mongers and public companies is a pressing policy concern.

A number of possible responses come to mind.

First, Regulation FD could be amended to allow the chairman of the SEC to waive the rule for specific companies in extraordinary situations. This might help a business in dire circumstances, though it runs the risk of being misused.

Permitting emergency communications forces one to weigh the risks of allowing insider profits against the possibility that an otherwise worthy company will be destroyed.

Rewrite the Rule

An alternative would be to rewrite Reg FD. After all, Reg FD doesn't only constrain the distribution of useful information during times of crisis.

A study by economists Armando Gomes, Gary Gorton, and Leonardo Madureira of the Wharton School at the University of Pennsylvania found that earnings-forecast errors for small companies skyrocketed after Reg FD was passed, suggesting that it is mucking up information transmission even in normal times.

Add it all together, and it becomes clear that starting over might not be a bad idea.

Until the law is changed, it is important that companies have a plan ready for rumor crises. If they don't, they may find themselves spending most of their time during a crisis talking about Reg FD.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.