Sept. 18 (Bloomberg) -- New York Attorney General Andrew Cuomo is investigating short sellers of Lehman Brothers Holdings Inc., American International Group Inc. and other financial companies to see if investors spread false information to drive down stock prices.

The ``wide-ranging'' probe will also examine trades of New York-based securities firms Morgan Stanley and Goldman Sachs Group Inc., which have been targets of short sales this week, according to Cuomo.

``I believe the federal government has been ineffective when it comes to regulating these markets,'' Cuomo said today in a conference call. ``We want to stabilize the market. The market needs stability now.''

Short sellers have come under scrutiny from regulators and executives as shares of some of the biggest investment firms have plummeted during the deepening credit crunch and the collapses of several Wall Street institutions.

Morgan Stanley issued a statement praising the investigation of ``manipulative and fraudulent conduct.'' Goldman Sachs spokesman Lucas Van Praag and AIG spokesman Peter Tulupman didn't immediately return calls for comment. Lehman spokesman Mark Lane declined to comment.

The U.S. Securities and Exchange Commission adopted two regulations yesterday that may pressure traders and brokers to actually borrow shares used in all short sales, amid concern investors are driving down prices by flooding markets with sell orders. A third rule makes it a securities fraud when sellers deceive brokers about delivering borrowed shares to buyers.

Short Sales

Short sellers try to profit by betting stock prices will fall. In a short sale, traders borrow shares from their broker that they then sell. If the price drops, they pocket the difference when they buy back the stock and return it.

In a practice called naked short selling, traders never borrow the shares, raising concerns that investors are flooding markets with sell orders to drive down prices.

``My office will investigate and prosecute short sellers who spread bad information and false rumors and conspire to bring down a company's stock price or engage in other manipulative or fraudulent conduct,'' Cuomo said.

Cuomo said he'll use a New York securities-fraud law called the Martin Act to pursue criminal and civil actions for investors over illegal sales. ``I want the short sellers to know today that I am watching,'' he said.

Freeze Proposal

Cuomo also said the SEC should temporarily freeze short selling of financial-sector stock.

Morgan Stanley said in a statement today it supports the proposed temporary freeze, ``given the extreme and unprecedented movements in the market that are unsupported by the fundamentals of individual stocks.''

Executives such as Morgan Stanley Chief Executive Officer John Mack and lawmakers including Christopher Dodd, chairman of the U.S. Senate Banking Committee, said short sellers may be spreading false information and using abusive tactics to attack companies.

In a memo to employees yesterday, Mack lambasted short sellers for pushing his firm's shares lower, and said the management committee is ``taking every step possible to stop this irresponsible action in the market.''

Morgan Stanley fell yesterday as the credit crunch fueled concern its funding sources are drying up. Lehman Brothers filed for bankruptcy earlier this week and Merrill Lynch & Co. sold itself to Bank of America Corp. AIG was taken over by the Federal Reserve on Sept. 16 in exchange for an $85 billion loan.

Hedge Fund Disclosure

The SEC also said yesterday it may require hedge funds to disclose their short-sale positions and plans to subpoena the funds' communication records in an effort to stem turmoil in stock markets.

SEC Chairman Christopher Cox said in a statement that hedge funds and investors managing more than $100 million in securities would be ``required to promptly begin public reporting of their daily short positions.''

The disclosure rule to become binding must be approved by the five SEC commissioners. Hedge funds, private pools of capital whose managers participate substantially from any profits on invested money, prefer to keep their positions secret to prevent other traders from stealing their strategies.

California Attorney General Edmund G. Brown Jr. isn't investigating short sales, his spokeswoman Christine Gasparac said.

Morgan Stanley rose 80 cents, or 3.6 percent, to $22.55 at 4:15 p.m. in New York Stock Exchange composite trading. Goldman Sachs fell $6.50, or 5.6 percent, to $108.

To contact the reporter on this story: Erik Larson in New York at elarson4@bloomberg.net.

Last Updated: September 18, 2008 17:06 EDT