By David Scheer — March 18, 2008 17:16 EDT

March 18 (Bloomberg) — U.S. regulators are investigating whether traders illegally sought to force Bear Stearns Cos. shares into a tailspin last week by spreading false information about the firms finances, two people familiar with the inquiry said.

The Securities and Exchange Commission probe is focusing on whether hedge funds or other investors bet on a drop in the companys shares while disseminating rumors that the New York-based firm was nearing collapse, said the people, who declined to be identified because the inquiry isnt public. The New York Stock Exchanges regulatory arm is also involved in the investigation, the people said.

Speculation about a cash shortage spurred customers and lenders to pull money from Bear Stearns last week, driving the shares down 57 percent between March 7 and March 14. Two days later, the fifth-largest U.S. securities firm was acquired by JPMorgan Chase & Co. for $2 a share. The companys decline coincided with a surge in investor bets that the stock price would plunge. The SECs probe is unusual because most of the regulators stock-manipulation cases focus on penny stocks.

«The commission is in uncharted territory, said Peter Henning. a former U.S. Justice Department prosecutor who teaches at Wayne State University Law School in Detroit. «The problem will be separating out the trading from the noise in the market. There was a lot of speculation about Bear.

Shareholder Losses

SEC spokesman John Nester and NYSE spokesman Scott Peterson declined to comment. Bear Stearns spokesman Russell Sherman didnt return a phone call seeking comment. The SEC is seeking to question traders who profited from options or short sales, one of the people familiar with the probe said.

The case underscores regulators concern that malicious rumors have the potential to fuel market panic and exacerbate shareholder losses on financial stocks. Bear Stearns had more than $17 billion in cash and salable assets on March 11 when lenders and customers began removing funds, the SEC said in a March 14 statement.

Bear Stearns Chief Executive Officer Alan Schwartz repeatedly sought to stanch the speculation last week. After clients pulled funds and creditors stopped renewing short-term loans, the Federal Reserve orchestrated a bailout on March 14 by providing funding to the company through JPMorgan.

«We have tried to confront and dispel these rumors and parse fact from fiction, Schwartz said in a statement that day. «Nevertheless, amidst this market chatter, our liquidity position in the last 24 hours had significantly deteriorated.

Piling On

The SEC today said it wouldnt rule out potential inquiries into the companys statements in the 60 days before the takeover by JPMorgan was announced. Though it is «premature to give assurances to JPMorgan about future probes, the SECs enforcement division would «favorably take into account the circumstances of the acquisition in considering any action, the agency said in a statement.

In the hunt for manipulation, it may be difficult for the SEC to discern who was trading illegally because investors may have been «piling on as speculation spread, said James Cox. a securities law professor at Duke University in Durham, North Carolina.

To prevail in a such a case, the SEC would have to show that a trader intentionally spread false information about Bear Stearns while seeking to profit from its potential affect on the shares, he said.

Bear Stearns is the biggest financial blowup since hedge fund Long-Term Capital Management LPs $3.6 billion rescue almost a decade ago. The losses end 85 years of independence for a firm that survived the Great Depression. In all, banks have reported $195 billion of asset writedowns and credit losses linked to subprime home loans since the start of 2007.

To contact the reporter on this story: David Scheer in Washington at dscheer@bloomberg.net.

To contact the editor responsible for this story: Otis Bilodeau at obilodeau@bloomberg.net.