Wall Street's regulator has launched a formal inquiry into whether hedge funds and other market participants sought to deliberately circulate false rumours about Lehman Brothers over the last few days in order to profit from short-selling shares in the investment bank, The Times has learnt.

On Monday, shares in Lehman Brothers fell by as much as 40 per cent amid panic that another Wall Street bank was experiencing severe funding problems. While all investment banking stocks tumbled on Monday, Lehman's rivals were broadly down around just 10 per cent.

The Securities and Exchange Commission (SEC) is now investigating whether hedge funds and other dealers in the equity market had sought to drive down Lehman's stock price by disseminating unfounded rumours about the bank's liquidity position.

As the rumours gained pace, and Lehman's stock declined, Richard Fuld, the bank's chairman and chief executive, sought to quash the speculation on Monday by issuing a statement insisting the group had $35 billion (£17.5 billion) of cash and liquid assets and a further $160 billion of unencumbered assets that could be sold to generate cash.

Yesterday, Lehman's shares were trading up 1 per cent at $47 each, having recovered from the severe fall on Monday when the stock hit $22.

While it is difficult to prove that a market participant deliberately started a false and damaging rumour to profit from a falling share price, any trader found to have done so would have breached Wall Street's market manipulation rules.

The SEC has already launched a formal investigation into trading in Bear Stearns shares leading up to its rescue acquisition by JP Morgan Chase on Sunday night.

In an unusual move, the SEC issued a written statement yesterday outlining the remit of its inquiry into information that was disseminated in the market about Bear Stearns in the last two months.

The SEC said its enforcement division wrote a letter as JP Morgan Chase was negotiating to take over Bear. The letter addressed to JP Morgan concerned "investigations and potential future inquiries into conduct and statements by Bear Stearns before the public announcement of the transaction with JP Morgan".

It added: "Among the things the Division looks for are potential indications of insider trading or manipulation of markets through the dissemination of false or misleading information to investors by companies or other market participants."

The SEC declined to comment.

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