Shock Wave: The Anatomy of the Emulex Fiasco

When Emulex (EMLX Quote) stock plunged Friday morning, investors assumed it was business as usual: Just another market darling headed for the scrap heap.

But this was no garden-variety blowup. At the end of trading Friday, questions surrounding Emulex's plunge were far from resolved. Regulators and exchange authorities were examining the possibility of illegal trading and Wall Street was recalling the aftermath of past press-release hoaxes. Some investors who sold on the first whiff of bad news were surely in the red at day's end. Meanwhile, the company said it was on track to meet all projections and to keep growing.

So unfolded the most jarring day this summer on Wall Street.

Steep Plunge

A press release posted around 9:30 a.m. EDT on the Internet reported an earnings restatement, a top executive's departure and a probe of accounting regularities by the Securities and Exchange Commission. The individual investors and money managers who had ridden Emulex to a 171% gain since mid-April started dumping their stock.

By 10:32 a.m., when Nasdaq halted Emulex trading, the stock, which had fallen as much as 62%, was down 51%.

"It went from 100 to 70 in three or four minutes," says one New York brokerage trader. "People were hitting the stock wherever they could, 5 and 6 points below the bid and offer." Ultimately the stock slid as low as 45, more than 67 points below its Thursday close.

"There were some massive offers in the stock," the New York trader says, noting that mutual funds, hedge funds, endowments and pension plans owned roughly 70% of it.

The Means of Production

The perpetrator of the fraud used Internet Wire, a public relations distribution service in Los Angeles, to spread the word. The charge for a release like the one that briefly took $2.5 billion of market capitalization out of Emulex: $325. Internet Wire is a six-year-old operation, a spokesman says, emphasizing that it is cooperating with authorities.

Whatever the hoax's origin, it was dutifully picked up by the major business wires and television stations. That served to stir the masses.

That said, the manager of one New York-based hedge fund that owns Emulex and didn't sell Friday says he was initially suspicious when he saw the press release: "It was so juvenile. It capitalized words for no reason." In addition, he thought it odd that trading in the stock was halted after the press release was issued, since companies typically request a halt before they issue big news.

Indeed, the release's headline highlights a supposed SEC investigation and the resignation of the CEO. But the text of the release fails to mention those actions. The text rambles about restated fiscal fourth-quarter results and promises further information at 5 p.m. EDT.

In any case, once trading resumed at 1:30 p.m. EDT, Emulex stock jumped, quickly regaining most of the ground lost in the morning.

The Aftermath

Now begins the hunt for the perpetrator. An FBI spokesman says both its New York and Los Angeles offices are looking into the hoax.

The Chicago Board Options Exchange said the "unusual" trading in Emulex options Friday "has triggered an intense investigation." The options also trade on the American Stock Exchange, the Philadelphia Stock Exchange and the Pacific Exchange. The PHLX and P-Coast said they are also looking into the trading in the options. The Amex has a policy not to comment on possible investigations.

The incident is reminiscent of last year's hoax involving PairGain, in which a phony news story was planted on an Internet message board saying the company was being acquired. The FBI caught up a week later with Gary Hoke, the 25-year-old company employee who planted the story.

When Hoke posted the fake Bloomberg story on a message board on April 7, 1999, PairGain jumped 30% before the hoax was exposed. It closed up 10% that day. PairGain was subsequently acquired by broadband player ADC Telecommunications (ADCT Quote) for $18.92 a share, less than a dollar above the hoax-takeout price.

In August of last year, Hoke was sentenced to five years' probation and five months of home detention and ordered to pay $92,000 in restitution to 30 investors deemed victims.

Stunning

One lucky soul is Tom Bleakley, manager of the (NAGQX Quote)Nicholas Applegate Small Cap Growth fund. He sold out of the stock recently because it got too big for his fund. But the hoax stunned him.

"I've never seen anything like this," Bleakley says. "When I looked at it, I assumed it was true."

Of course, it wasn't.