BREAKING NEWS: Supreme Court Rules On Manning v. Merrill Lynch

May 16, 2016

In Greg Manning et al., Plaintiffs, v. Merrill Lynch, Pierce,  Fenner & Smith, Inc. et al., Defendants (Opinion and Order on Interlocutory Appeal, United States District Court for the District of New Jersey, 12-4466, May 23, 2013), a group of Escala Group, Inc. shareholders filed a lawsuit in the Superior Court of New Jersey alleging that Defendants Merrill Lynch, Pierce, Fenner & Smith, Inc; Knight Capital Americas, L.P.; UBS Securities, L.L.C.; E*TRADE Capital Markets, L.L.C.; National Financial Services, L.L.C. had engaged in the naked short selling of Escala stock. Plaintiffs alleged that in furtherance of such naked shorting, the Defendants had electronically manufactured fictitious and unauthorized phantom shares and, as a result, the shareholders found their voting rights diluted and their shares declined in value.  

Making a Federal Case?

As set forth in an Amended Complaint, Plaintiffs pleaded 10 causes of action under New Jersey state law, among which were New Jersey Racketeer Influenced and Corrupt Organizations Act ("RICO") claims and various common law claims. The Amended Complaint mentions the short selling requirements as set forth in federal Regulation SHO, and, moreover, asserts that federal law was repeatedly violated by the alleged naked shorting. Under New Jersey law, however, there is no regulation similar to federal Regulation SHO. Clearly, the stage was set for a dispute as to whether Plaintiffs had pled a fact pattern that belonged before a federal District Court rather than the Superior Court of New Jersey, which is a state court.

Although short selling of stocks is legal when compliant with federal Regulation SHO, some naked short selling may run afoul of federal antifraud laws, as well as Regulation SHO. As explained on the Securities and Exchange Commission ("SEC") "Key Points About Regulation SHO" website page:

II. "Naked" Short Sales

In a "naked" short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period.[3] As a result, the seller fails to deliver securities to the buyer when delivery is due (known as a "failure to deliver" or "fail").

Failures to deliver may result from either a short or a long sale. There may be legitimate reasons for a failure to deliver. For example, human or mechanical errors or processing delays can result from transferring securities in physical certificate rather than book-entry form, thus causing a failure to deliver on a long sale within the normal three-day settlement period. A fail may also result from "naked" short selling. For example, market makers who sell short thinly traded, illiquid stock in response to customer demand may encounter difficulty in obtaining securities when the time for delivery arrives.

"Naked" short selling is not necessarily a violation of the federal securities laws or the Commission's rules. Indeed, in certain circumstances, "naked" short selling contributes to market liquidity. For example, broker-dealers that make a market in a security[4] generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers. Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market. This may occur, for example, if there is a sudden surge in buying interest in that security, or if few investors are selling the security at that time. Because it may take a market maker considerable time to purchase or arrange to borrow the security, a market maker engaged in bona fide market making, particularly in a fast-moving market, may need to sell the security short without having arranged to borrow shares. This is especially true for market makers in thinly traded, illiquid stocks as there may be few shares available to purchase or borrow at a given time.

. . .

1. Is all "naked" short selling abusive or illegal?

When considering "naked" short selling, it is important to know which activity is the focus of discussion.

Selling stock short without having located stock for delivery at settlement. This activity would violate Regulation SHO, except for short sales by market makers engaged in bona fide market making. Market makers engaged in bona fide market making do not have to locate stock before selling short, because they need to be able to provide liquidity. However, market makers are not excepted from Regulation SHO's close-out and pre-borrow requirements.

Selling stock short and failing to deliver shares at the time of settlement. Rule 204 requires firms that clear and settle trades to deliver securities to a registered clearing agency for clearance and settlement on a long or short sale in any equity security by the settlement date or to take action to close out failures to deliver by borrowing or purchasing securities of like kind and quantity by no later than the beginning of regular trading hours on T+4 for short sale fails or T+6 for long sale fails and fails attributable to bona fide market making. If a firm that clears and settles trades has a failure to deliver that is not closed out by the beginning of regular trading hours on T+4 or T+6, as applicable, the firm has violated Rule 204 and the firm, and any broker-dealer from which it receives trades for clearance and settlement, is subject to the pre-borrow requirement for that security.

Selling stock short without having located stock for delivery at settlement and failing to deliver shares at the time of settlement. This activity may violate Regulation SHO's locate and close-out requirements, as explained above. In addition, in fall 2008 the Commission adopted Rule 10b-21, referred to as the "naked" short selling antifraud rule. Those who deceive about their intention or ability to deliver securities in time for settlement are committing fraud, in violation of Rule 10b-21, when they fail to deliver securities by the settlement date.

Selling stock short and failing to deliver shares at the time of settlement with the purpose of driving down the security's price. This manipulative activity, in general, would violate various securities laws, including Rule 10b-5 under the Exchange Act.

Removal From State to Federal Court

Defendants removed the suit from the Superior Court of New Jersey to the United States District Court for the District of New Jersey ("DNJ"), premised on the existence of federal-question jurisdiction. Plaintiffs sought remand.

On December 31, 2012, a federal Magistrate issued a Report and Recommendation favoring Plaintiffs' motion to remand based upon the premise that they may succeed on their New Jersey RICO claims and state common law claims without the necessity to demonstrated federal law liability and, further, that the claims did not necessarily raise a substantive federal law question.

Notwithstanding the Magistrate's recommendation, the DNJ's March 20, 2013, Opinion found that the case was premised upon and its very resolution depended upon an alleged violation of a federal Exchange Act regulation. In a rare move, DNJ certified an interlocutory appeal to United States Court of Appeals for the Third Circuit ("3Cir") on the issue of the appropriateness of remand. The District Court ("DNJ") summarized the procedural posture of the case as follows:

Defendants removed the action to this Court on July 17, 2012. At that time, as now, Defendants contend that removal is proper on two separate grounds: (1) the Court is vested with exclusive jurisdiction under Section 27 of the Securities Exchange Act of 1934, 15 U.S.C. § 78aa ("Exchange Act" or the "Act"); and (2) the Court is vested with original jurisdiction because Plaintiffs' claims raise, and arise under, federal law. Plaintiffs filed a motion to remand and for an award of attorneys' fees on August 16, 2012. (CM/ECF No. 11). On March 20, 2013, this Court denied Plaintiffs' motion. (CM/ECF Nos. 48, 49). Plaintiffs filed the instant motion for leave to appeal or, in the alternative, for reconsideration on April 18, 2013. (CM/ECF No. 58).1

Page 2 of the DNJ Opinion and Order on Interlocutory Appeal

3Cir Orders Remand to DNJ

In Greg Manning, et al., Appellants, v. Merrill Lynch, Pierce, Fenner & Smith, Inc. et al.,(Opinion, 3Cir, 13-3693, November 10, 2013), we have this summary:

After the District Court denied Plaintiffs' motion to remand this case to New Jersey state court, we granted their petition for an interlocutory appeal. The issue before us is whether there is federal-question jurisdiction over Plaintiffs' state-law claims, which allege that defendants manipulated the price of a stock via abusive "naked" short sales. Short sales are subject to detailed federal regulation under Regulation SHO. New Jersey does not have an analogous provision. However, the question of whether the naked short selling at issue in this case violates New Jersey law (including the state's general securities fraud provisions) need not be answered by reference to Regulation SHO. Because the success of Plaintiffs' state-law causes of action does not "necessarily" depend upon the contents of federal law, this case does not "arise under" the laws of the United States. The presence of an exclusive jurisdiction provision governing Regulation SHO does not change the analysis, as such provisions cannot independently generate jurisdiction.

We hold that there is no federal-question jurisdiction over this suit. Accordingly, we will reverse the order denying remand, and direct the District Court to remand this case to the Superior Court of New Jersey.

Page 5 - 6 of 3Cir Opinion

Supreme Court Cert

In Merrill Lynch v. Manning (Cert. Granted, United States Supreme Court, 14-1132) the Supreme Court ("SCT") granted cert on June 30, 2015 as to the following Question Presented:

Section 27 of the Securities Exchange Act of 1934 provides that federal courts "shall have exclusive jurisdiction" over "violations of [the Act] or the rules and regulations thereunder, and of all suits in equity and actions at law brought to enforce any liability or duty created by [the Act] or the rules and regulations thereunder." 15 U.S.C. § 78aa(a).

The Fifth and Ninth Circuits have held that §27 provides federal jurisdiction over statelaw claims seeking to establish liability based on violations the Act or its regulations or seeking to enforce duties created by the Act or its regulations. In acknowledged conflict with those decisions, the Third Circuit in this case joined the Second Circuit in holding that § 27 does not itself create federal jurisdiction over state-law claims that otherwise fall within its terms.

The question presented is:

Whether § 27 of the Securities Exchange Act 1934 provides federal jurisdiction over state-law claims seeking to establish liability based on violations of the Act or its regulations or seeking to enforce duties created by the Act or its regulations.

Supreme Court Opinion

The Supreme Court AFFIRMED the 3Cir in Merrill Lynch, Pierce, Fenner & Smith Inc. et al. v. Manning, et al. (Opinion, 14-1132 / May 16, 2016), Kagan delivered the Opinion joined by Roberts, Kennedy, Ginsburg, Breyer, and Alito, Thomas and Sotomayor concurred.

As set forth in the Syllabus to the Supreme Court's Opinion:

Respondent Greg Manning held over two million shares of stock in Escala Group, Inc. He claims that he lost most of his investment when the share price plummeted after petitioners, Merrill Lynch and other financial institutions (collectively, Merrill Lynch), devalued Escala through "naked short sales" of its stock. Unlike a typical short sale, where a person 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 seller in a "naked" short sale does not borrow the stock he puts on the market, and so never delivers the promised shares to the buyer. This practice, which can injure shareholders by driving down a stock's price, is regulated by the Securities and Exchange Commission's Regulation SHO, which prohibits shortsellers from intentionally failing to deliver securities, thereby curbing market manipulation.

Manning and other former Escala shareholders (collectively, Manning) filed suit in New Jersey state court, alleging that Merrill Lynch's actions violated New Jersey law. Though Manning chose not to bring any claims under federal securities laws or rules, his complaint referred explicitly to Regulation SHO, cataloguing past accusations against Merrill Lynch for flouting its requirements and suggesting that the transactions at issue had again violated the regulation. Merrill Lynch removed the case to Federal District Court, asserting federal jurisdiction on two grounds. First, it invoked the general federal question statute, 28 U. S. C. §1331, which grants district courts jurisdiction of "all civil actions arising under" federal law. It also invoked §27 the Securities Exchange Act of 1934 (Exchange Act), which grants federal district courts exclusive jurisdiction "of all suits in eq-uity and actions at law brought to enforce any liability or duty created by [the Exchange Act] or the rules or regulations thereunder." 15 U. S. C. §78aa(a). Manning moved to remand the case to state court, arguing that neither statute gave the federal court authority to adjudicate his state-law claims. The District Court denied his motion, but the Third Circuit reversed. The court first decided that §1331 did not confer jurisdiction, because Manning's claims all arose under state law and did not necessarily raise any federal issues. Nor was the District Court the appropriate forum under §27 of the Exchange Act, which, the court held, covers only those cases that would satisfy §1331's "arising under" test for general federal jurisdiction.

Held: The jurisdictional test established by §27 is the same as §1331's test for deciding if a case "arises under" a federal law. Pp. 4-18.

(a) Section 27's text more readily supports this meaning than it does the parties' two alternatives. Merrill Lynch argues that §27's plain language requires an expansive rule: Any suit that either explicitly or implicitly asserts a breach of an Exchange Act duty is "brought to enforce" that duty even if the plaintiff seeks relief solely under state law. Under the natural reading of that text, however, §27 confers federal jurisdiction when an action is commenced in order to give effect to an Exchange Act requirement. The "brought to enforce" language thus stops short of embracing any complaint that happens to mention a duty established by the Exchange Act. Meanwhile, Manning's far more restrictive interpretation-that a suit is "brought to enforce" only if it is brought directly under that statute- veers too far in the opposite direction. Instead, §27's language is best read to capture both suits brought under the Exchange Act and the rare suit in which a state-law claim rises and falls on the plaintiff's ability to prove the violation of a federal duty. An existing jurisdictional test well captures both of these classes of suits "brought to enforce" such a duty: 28 U. S. C. §1331's provision of federal jurisdiction of all civil actions "arising under" federal law. Federal jurisdiction most often attaches when federal law creates the cause of action asserted, but it may also attach when the state-law claim "necessarily raise[s] a stated federal issue, actually disputed and substantial, which a federal forum may entertain without disturbing any congressionally approved balance" of federal and state power. Grable & Sons Metal Products, Inc. v. Darue Engineering & Mfg., 545 U. S. 308, 314. Pp. 5-10.

(b) This Court's precedents interpreting the term "brought to enforce" have likewise interpreted §27's jurisdictional grant as coextensive with the Court's construction of §1331's "arising under" standard. See Pan American, 366 U. S. 656; Matsushita Elec. Industrial Co. v. Epstein, 516 U. S. 367. Pp. 10-14.

(c) Construing §27, consistent with both text and precedent, to cover suits that arise under the Exchange Act serves the goals the Court has consistently underscored in interpreting jurisdictional statutes. It gives due deference to the important role of state courts. And it promotes "administrative simplicity[, which] is a major virtue in a jurisdictional statute." Hertz Corp. v. Friend, 559 U. S. 77, 94. Both judges and litigants are familiar with the "arising under" standard and how it works, and that test generally provides ready answers to jurisdictional questions. Pp. 14-18.

772 F. 3d 158, affirmed.