Attorney: Justin Nematzadeh
Pomerantz Monitor July/August 2016
Federal courts have exclusive jurisdiction over claims alleging violations of the Securities Exchange Act, such as securities fraud. But in some cases the same conduct can violate both the federal securities laws and state laws; and in some of those cases investors may choose, for a variety of tactical reasons, to bring their claims in state court, under state law only. Naturally, defendants look for ways to fight back. In class action cases, Congress passed a law a few years ago that effectively federalizes all state law cases challenging conduct that could have been pleaded as securities laws violations, whether investors pleaded federal claims or not. But that leaves open the question of when and whether claims brought by individual investors can proceed in state court.
In a case involving Merrill Lynch, the United States Supreme Court recently answered that question. It held that a state law case does not have to be brought in federal court just because defendants’ alleged conduct could also be a violation of the Securities Exchange Act.
In that case, former shareholders of Escala Group, Inc. sued Merrill Lynch and several other financial institutions for manipulating the price of Escala stock through “naked short sales” of its stock. In a typical short sale, the seller borrows stock from a broker, sells it to a buyer on the open market, and later purchases the same number of shares to return to the broker. The short seller pockets the potential stock price decline between the time of selling the borrowed shares and buying the replacement shares to pay back the broker’s loan.
But in a naked short sale, the seller has not borrowed the stock that he is selling short. In market manipulation cases, for example, defendants typically flood the market with a large number of sell orders, but it may not be possible to borrow enough shares to cover all these transactions. In those cases, the short seller may not be able to deliver the sold shares to the buyer when the transaction is scheduled to close. Naked short selling can drive down a company’s stock price, injuring investors. SEC regulations aim to curb market manipulation by prohibiting short sellers from intentionally failing to deliver securities.
In the Merrill Lynch case, plaintiffs sued defendants in New Jersey state court for naked short selling under several New Jersey statutes and common law causes of action. Although not alleging violations of the federal securities laws, the complaint catalogued past accusations against defendants for flouting securities regulations, couching the naked short-selling description in terms suggesting that defendants had again violated this regulation.
Defendants attempted to remove the case to federal court, plaintiffs objected, and the ensuing struggle played out all the way to the Supreme Court. There defendants argued that plaintiffs had explicitly or implicitly asserted that defendants had breached an Exchange Act duty, so the suit was “brought to enforce” that duty and gave federal court exclusive jurisdiction. Under this argument, the case would have remained in federal court even if plaintiffs had sought relief only under state law and could have prevailed without proving a breach of an Exchange Act duty. Plaintiffs countered by arguing that a suit is “brought to enforce” the Exchange Act’s duties only if the asserted causes of action were created by the Exchange Act, which was not the case here.
The Supreme Court adopted a middle ground, ultimately siding with plaintiffs and remanding the suit to state court. Adopting a “natural reading” of the exclusive jurisdiction provision, the Court held that it did not apply just because a complaint mentions a duty established by the Exchange Act. The Supreme Court held that exclusive federal jurisdiction applied only when a complaint (i) directly asserted an Exchange Act cause of action or (ii) asserted a state law cause of action that would require the plaintiff to demonstrate that defendants breached an Exchange Act duty. Plaintiffs’ suit would have fallen under the compass of the second prong of this interpretation if the New Jersey statutes made illegal “any violation of the Exchange Act involving naked short selling.”
Noting respect for state courts, the Supreme Court stated that its decisions reflected a “deeply felt and traditional reluctance . . . to expand the jurisdiction of federal courts through a broad reading of jurisdictional statutes.” Deference to state courts was stronger here to limit Section 27 of the Exchange Act’s mandated—rather than permitted— federal jurisdiction, depriving state courts of all ability to adjudicate claims. The Supreme Court stated that Congress likely contemplated that some complaints intermingling state and federal questions would be brought in state court by specifically affirming the capacity of state courts to adjudicate state law securities actions. Moreover, the exclusive jurisdiction provision does nothing to prevent state courts from resolving Exchange Act questions resulting from defenses or counterclaims.
After Merrill Lynch investors can avail themselves of the additional weapon of state court in suing for market manipulation by asserting causes of action under state laws that do not necessitate a showing of a federal-law breach. In doing so, they can even allege defendants’ federal-law violations for similar conduct.