Securities Regulation Daily Narrow reading of '34 Act returns Merrill short-selling case to state court
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Monday, May 16, 2016

Narrow reading of '34 Act returns Merrill short-selling case to state court

By Anne Sherry, J.D.

An investor's complaint that Merrill Lynch drove down the price of his investment through naked short selling belongs in state, not federal, court. The Supreme Court held that Exchange Act Section 27, which places lawsuits brought to enforce the Act and its rules in federal court, establishes the same jurisdictional test as the "arising under" test of the general federal question statute (28 U.S.C. §1331). While the complaint referenced Regulation SHO, it brought only state-law claims that did not necessarily raise any federal issue (Merrill Lynch, Pierce, Fenner & Smith Inc. v. Manning, May 16, 2016, Kagan, E.).

Short selling. The plaintiff held more than two million shares of stock in Escala Group, Inc., but lost most of his investment when the share price plummeted between 2006 and 2007. He sued Merrill Lynch and several other financial institutions for devaluing Escala through naked short sales of its stock. Although the investor's complaint referenced the SEC's Regulation SHO, he chose not to bring any federal claims. Instead, the claims were based on New Jersey statutory and common law, including the state's racketeering and securities laws.

Removed to federal court. Merrill Lynch removed the case from New Jersey state court to federal district court, maintaining that §1331, which grants district courts jurisdiction of "all civil actions arising under" federal law, applied. Second, Merrill Lynch invoked Section 27 of the Exchange Act, which grants district courts exclusive jurisdiction of "all suits in equity and actions at law brought to enforce any liability or duty created by [the Exchange Act] or the rules and regulations thereunder." The district court denied the investor's motion to remand the case to state court, but the Third Circuit reversed. After deciding that §1331 did not confer jurisdiction because none of the state-law claims necessarily raised a federal issue, the appellate court held that Section 27 covered only those Exchange Act cases that would satisfy §1331.

Circuit split lands case in Supreme Court. The Supreme Court granted certiorari due to a circuit split on this issue, with the Second and now Third Circuits construing Section 27 narrowly, compared to a broad reading from the Fifth and Ninth Circuits. All eight Justices voted to affirm, with Justices Thomas and Sotomayor concurring in the judgment.

§1331 strikes balance between too-strict and too-broad readings. Writing for the majority, Justice Kagan differed with Merrill's characterization of Section 27 as requiring an expansive, contextual reading. A natural reading "confers federal jurisdiction when an action is commenced in order to give effect to an exchange Act requirement." This language "stops short of embracing any complaint that happens to mention a duty established by the Exchange Act," she explained. Neither would the Court embrace the investor's reading, which went too far in the opposite direction by restricting Section 27's reach to suits that delineate claims created by the Exchange Act. Although this view was "better than Merrill Lynch's," it overlooked state-law claims that rise or fall on the violation of a federal duty. Such a claim, if it necessarily depended on a showing that the defendant violated the Exchange Act, could also fall within the purview of Section 27.

The general federal question statute, §1331, "well captures" the two classes of suits "brought to enforce" an Exchange Act duty. Federal jurisdiction typically attaches when federal law creates the cause of action asserted, but even when a claim finds its origins in state law, arising-under jurisdiction still lies if the state-law claim necessarily raises a stated federal issue. Accordingly, the Court agreed with the Third Circuit that Section 27's jurisdictional test matches the Supreme Court's formulation of §1331. "If (but only if) such a case meets the ‘arising under’ standard, §27 commands that it go to federal court," the Court held.

The decision is consistent with prior decisions of the Court reading statutory "brought to enforce" language as coextensive with its construction of "arising under." Construing Section 27 to cover suits arising under the Exchange Act gives due deference to the important role of state courts in the federal system, and it is a more straightforward and administrable standard than that offered by Merrill Lynch. Out of respect for state courts, the Court has repeatedly declined to construe federal jurisdictional statutes more expansively than the fairest reading of their language requires. If anything, its reluctance to endorse a broad reading is stronger when the statute confers mandatory, rather than permissive, jurisdiction.

Concurring opinion. Justice Thomas wrote a concurring opinion in which Justice Sotomayor joined. Those Justices would remand the lawsuit to state court based only on the Exchange Act provision, not an "arising under" standard. The Exchange Act generally preserves other rights and remedies at law or equity, demonstrating that Congress contemplated the possibility of state litigation relating to securities transactions. A natural reading of Section 27 preserves the dual role for federal and state courts, confirming that mere allegations of Exchange Act breaches do not alone deprive state courts of jurisdiction. Justice Thomas would hold that Section 27 confers federal jurisdiction where a complaint alleges claims that necessarily depend on establishing a breach of an Exchange Act requirement. Under this test, the Third Circuit was correct to remand the case to state court because the claims did not require enforcement of the Exchange Act or its regulations.

The case is No. 14-1132.

Attorneys: Neal H. Flaster (Neal H. Flaster, L.L.C.) for Greg Manning. Brad M. Elias (O'Melveny & Myers LLP) for Merrill Lynch Pierce Fenner Smith Inc. James H. Bilton (Locke Lord LLP) for Knight Capital Americas, a/k/a Knight Equity Markets.

Companies: Merrill Lynch Pierce Fenner Smith Inc.; Knight Capital Americas, a/k/a Knight Equity Markets

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