updated 9/18/2008 5:31:18 PM ET 2008-09-18T21:31:18

New York state is launching an investigation into whether some traders used illegal tactics to drive down the stock price of several Wall Street firms.

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Attorney General Andrew Cuomo told reporters Thursday his office has received a “significant number” of complaints about short sellers, or investors who hope to profit by placing bets that a financial company’s stock will fall.

Short-selling is not illegal. But Cuomo said he will focus on whether short sellers engaged in conspiracy or spread rumors and bad information to influence the stock prices of Lehman Brothers Holdings Inc., American International Group Inc., Goldman Sachs Group Inc., Morgan Stanley and other firms that have been hammered in the ongoing financial crisis.

“I want the short sellers to know today that I am watching. If it’s proper and legal, they have nothing to worry about,” Cuomo said. “It is illegal, however, when such shorting is combined with the spread of false information in order to bring a company down.”

Short-selling occurs when traders borrow shares of a stock they expect will fall and sell them. If the stock does indeed fall, the traders buy the cheaper shares to cover the borrowed ones and profit from the difference.

Naked short-selling occurs when sellers don’t actually borrow the shares before selling them. It’s a practice some say is partially responsible for the huge drop in the shares of investment banks like Lehman, Merrill Lynch and Bear Stearns Cos., which JPMorgan Chase & Co. bought earlier this year.

Cuomo said he believes the federal government has been “ineffective” in dealing with short sellers and said his office would go after traders found to be illegally using the practice to manipulate markets.

“The markets need to be stabilized, and one way to help bring about such stability is to root out and deter short-selling that is based on the spread of false information,” Cuomo said.

Cuomo said the probe would employ the state’s powerful Martin Act, which provides criminal and civil enforcement powers for publicly traded companies.

The investigation comes amid growing international scrutiny over short-selling. Britain’s Financial Services Authority said Thursday it is temporarily banning short-selling of shares in publicly traded financial companies.

FSA chief executive Hector Sants said his organization still regards short-selling as a legitimate investment technique, but he says “extreme circumstances” have required new rules to protect against further financial turmoil.

On Wednesday, the Securities and Exchange Commission adopted rules it said would provide permanent protections against abusive “naked” short-selling.

The SEC this summer issued a temporary emergency ban on naked short-selling in the stocks of mortgage finance giants Fannie Mae and Freddie Mac and 17 large investment banks, but the new rules apply to trading in the broader market.

SEC Chairman Christopher Cox also said he planned to ask his four fellow commissioners to consider on an emergency basis a new rule that would require hedge funds and other large-scale investors to disclose their short positions — the stocks they have borrowed and sold but not yet replaced.

Cuomo called the SEC measures a positive step but said “more is needed.” He called on the agency to “immediately freeze short-selling of financial sector stocks on a temporary basis,” just as British regulators have done.

In a statement, Morgan Stanley applauded the probe and said it also supports a temporary freeze on short-selling of financial stocks, “given the extreme and unprecedented movements in the market that are unsupported by the fundamentals of individual stocks.”

Copyright 2008 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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