SCOTUS Rules That Lawsuit Alleging Naked Short Selling Can Proceed in State Court
In a unanimous decision that may lead to an increase in the trend of state court suits involving securities litigation, the US Supreme Court ruled this week that an action related to the short sale of securities could proceed in state court. In Merrill Lynch, Pierce, Fenner & Smith Inc. v. Manning, the Court held that the exclusive jurisdiction of securities claims in federal court provided by the Securities Exchange Act is limited to claims “arising under” the Exchange Act.
Despite Congress’s consistent attempts to direct securities cases to federal court, plaintiffs have been seeking to devise ways to assert securities-related claims in state court alleging state law causes of action in an attempt to find more plaintiff friendly fora or to avoid automatic discovery stays imposed by federal law. The Court’s Manning decision provides plaintiffs a tool to continue to do so.
In Manning, the plaintiff filed suit in New Jersey state court alleging that several financial institutions facilitated and engaged in naked short sales of stock (i.e., a short sale where the seller never delivers the stock to the buyer), resulting in a devaluing of that stock. Naked short sales are regulated at the federal level by Securities and Exchange Commission Regulation SHO, which prohibits short sellers from intentionally failing to deliver securities. While the plaintiff’s complaint suggested that the short sales violated Regulation SHO, plaintiff only asserted New Jersey statutory and common law claims and did not bring any claims under the federal securities laws.
Defendants removed to federal court on two grounds. First they invoked the general federal question jurisdiction statute, 18 U.S.C. § 1331, which grants the federal court jurisdiction of “all civil actions arising under” federal law. Second, they argued that the case belonged in federal court under Section 27 of the Securities Exchange Act, which grants the federal courts exclusive jurisdiction of “all suits in equity and actions at law brought to enforce any liability or duty created by” the Securities Exchange Act. The district court denied plaintiff’s motion to remand but the Third Circuit reversed, finding that all of the claims were brought under state law and none necessarily raised a federal issue. The Supreme Court granted certiorari to determine the scope of exclusive jurisdiction granted under Section 27 of the Exchange Act, which had been the subject of a circuit split.
The Supreme Court held that despite the wording differences between that statutory provision and 18 U.S.C. § 1331, the scope of lawsuits covered by each provision is the same and therefore the same jurisdictional test applies to both. In reaching its decision, the Supreme Court rejected defendants’ more expansive reading of Section 27 to include any action which either explicitly or implicitly asserts a violation of the Exchange Act as well as plaintiff’s more restrictive reading of Section 27 to preclude only suits brought directly under the Exchange Act.
Under the middle ground test adopted by the Supreme Court, a lawsuit “arises under” the Exchange Act and therefore satisfies Section 27 in two circumstances. First, Section 27 is satisfied when a plaintiff directly asserts causes of action created by the Exchange Act. Second, in more limited circumstances, Section 27 is satisfied when a state law cause of action is brought to enforce a duty created by the Exchange Act and the claim’s success depends on giving effect to the federal requirement—i.e., if New Jersey law specifically prohibited violations of the Exchange Act involving short selling. Because none of plaintiff’s claims were dependent on proving a violation of the Exchange Act, the jurisdictional test was not met and the case was remanded to state court.
In Manning, the Supreme Court made clear that a plaintiff’s allegation that the conduct underlying their state law claims also violated the federal securities laws will be insufficient for exclusive federal court jurisdiction under Section 27. As a result, plaintiffs bringing suit for state law claims in state court may start to reference violations of the federal securities laws more forcefully without expressing that the state law claims are premised on the violation of federal law. As the Supreme Court noted, it would be “hardly surprising” that a plaintiff alleging violation of state securities laws “might say the defendant previously breached a federal prohibition of similar conduct.”
In light of the Supreme Court’s emphasis on the important role of state courts in determining controversies, including those involving securities, we may begin to see a rise in state court litigation related to the securities industry.