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Sandell Under Shorting Scrutiny

A naked-shorting probe deepens.

Sandell Asset Management

is the mystery hedge fund that securities regulators claim tried to cash in on Hurricane Katrina.


Securities and Exchange Commission

last week formally notified the New York-based fund, which has more than $4 billion under management, that it could face a civil fraud action, sources say.

The potential regulatory charges arise from some short sales Sandell made in shares of Hibernia just before it was acquired late last year by

Capital One

(COF) - Get Capital One Financial Corporation Report


A spokesman for the hedge fund, which recently sent a letter to its investors alerting them to the possible action, declined to comment.

Last month

first reported that the SEC was investigating

an unidentified hedge fund for supposedly making improper short sales just as Katrina was laying waste to the bank's hometown. Regulators believed the hedge fund sought to profit from Wall Street speculation that the storm devastation would force Capital One to cut the price of its planned acquisition of Hibernia -- as it later did.

The unmasking of Sandell as the mystery hedge fund was first reported by the

New York Post

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Shorting a stock, or betting on its decline, is legal -- even if it means benefiting from someone else's misery. But the SEC is investigating allegations that the hedge fund ran afoul of securities laws by shorting Hibernia shares without first borrowing them from a broker.

The hedge fund, which reportedly is up 18% this year, was founded in 1998 by Thomas Sandell, a former senior managing director in

Bear Stearns'


risk arbitrage department.

Sources say some of the allegedly improper trades were executed by a number of big Wall Street firms, including

Morgan Stanley

(MS) - Get Morgan Stanley (MS) Report

. A Morgan Stanley spokeswoman declined to comment. Sources say the SEC has contacted the brokerages, but the firms are not under investigation.

In effect, the SEC is looking into the possibility that the hedge fund engaged in "naked shorting." In a traditional short sale, a bearish trader must first borrow shares from a broker and then sell them. The trader then hopes to pay off the loan at a later date with stock purchased at a lower price, pocketing the difference as profit.

But naked shorting lets traders defy the laws of supply and demand by shorting even when shares aren't available to borrow.

In the case of Sandell, regulators allege the hedge fund couldn't find any shares of Hibernia to borrow because so much of the stock had been taken out circulation in anticipation of the bank's merger with Capital One, which was supposed to close in September 2005. The government believes Sandell went ahead and shorted Hibernia shares anyway.

Ron Geffner, a partner with Sadis & Goldberg who represents many hedge funds, says if there's a "clear cut violation," it should be an easy case for the SEC. But he says it's possible the hedge fund made a mistake and believed the shares were available when it made the short sales.

Two years ago, the SEC and other securities regulators began cracking down on naked shorting in response to complaints from investors that some hedge funds were manipulating the marketplace. In response to those allegations, the SEC enacted a rule called Regulation SHO, which makes it more difficult for traders to engage in naked shorting.

Regulation SHO also stiffens the responsibility of Wall Street firms to combat naked shorting. The rule prohibits brokers from letting traders short a stock unless there are "reasonable grounds" for believing there are shares available to borrow.

In theory, Morgan Stanley and the other Wall Street firms that executed the short sales for Sandell could be at fault, if the regulators find the brokerages didn't sufficiently investigate the hedge fund's claim that it made arrangements to borrow the necessary shares. But at this time, sources say regulators believe the brokers are not at fault.