Justices Wary Of Moving 'Naked Shorts' Suit Out Of NJ Court
The high court held oral arguments in Merrill Lynch et al. v. Manning et al., a shareholder claim that could help define the parameters of state-based securities litigation. It came to the Supreme Court on an appeal from the Third Circuit, which held that Merrill Lynch Pierce Fenner & Smith Inc. couldn’t keep the case in federal court even though it deals with rules the U.S. Securities and Exchange Commission wrote about short selling.
During Tuesday's proceedings, an attorney for Merrill Lynch told the high court that Section 27 of the Securities Exchange Act gives federal courts exclusive jurisdiction over all suits that seek to enforce any duty created by the law or its regulations, even if the suit is also brought to enforce state law.
On those grounds, argued Jonathan Hacker of O’Melveny & Myers LLP, investors in Escala Group Ltd. shouldn’t be allowed to proceed in New Jersey Superior Court with a lawsuit that alleges Merrill Lynch and others manipulated the market through a naked short-selling campaign that would violate the requirements of Regulation SHO, the federal rules governing short selling.
But it didn’t take long for justices to pepper Hacker with questions, starting with what his interpretation of the Exchange Act preemption would mean for judicial review of cases, according to a transcript of the proceedings.
“Is the court obligated to do a search of all federal laws and regulations to know if this complaint might have a federal cause of action?” Justice Anthony Kennedy said.
Justice Antonin Scalia chimed in a few minutes later, saying, “That imposes quite a, quite an onerous task upon upon the federal district court, it seems to me."
“You have to sift through the complaint and see if any of the claimed causes of action under state law mirror a cause of action that happens to exist under federal law, without even the hint that they mention the federal statute,” he continued.
Hacker disagreed that courts would have to engage in that sort of review. Rather, it would be up to defendants like his clients to identify those matters brought under state law that seek to enforce a federal duty.
He further said that while the plaintiffs have brought fraud claims under state statutes, the success of those claims turns on proving a violation of Regulation SHO.
Members of the court, however, seemed unconvinced that the shareholder suit at hand was seeking to enforce federal law.
“As I understand your case, you would say that that person is suing to enforce a duty under federal law,” Justice Scalia said. "I would not say that. I would say that person is seeking to enforce the duty that state law creates, not the one that federal law creates."
Justice Stephen Breyer had another question. “So why isn't the SEC here?” he asked.
He was referring to the fact that the SEC, as the standard-setter of the federal securities laws, was not among the many groups, including the Securities Industry and Financial Markets Association and Public Citizen, that had submitted amicus briefs on the case.
Hacker didn’t have an explanation. “The SEC makes its own decisions,” he said. “And I certainly think this court cannot decide a case based ... on what the SEC hasn't said.”
“Curious,” Breyer replied.
The underlying suit was brought in New Jersey state court in 2012, asserting claims for violations of the state’s Racketeer Influenced and Corrupt Organizations Act and Uniform Securities Law.
Merrill Lynch, along with other defendants including the former Knight Capital Americas LP and E-Trade Capital Markets LLC, had the case removed to federal court. But a Third Circuit panel in November 2014 returned the claim to the Garden State.
The appeals court ruled that although stock short sales are subject to federal regulation under Regulation SHO — and New Jersey law lacks an analogous provision — the question of whether the naked short-selling at issue in the case violates the state's law can be answered without referring to Regulation SHO.
The banks petitioned the Supreme Court in March, telling the justices that the case is the “ideal vehicle” for resolving a split over the proper interpretation of Section 27 of the Exchange Act. The high court accepted the petition in June.
Arguing on behalf of the Escala Group shareholders, Peter Stris of Stris & Maher LLP said arguments that plaintiffs are relying on Regulation SHO misconstrue their suit.
“We are not relying on Reg SHO for any theory of liability, and here's why: We're bringing a straight-up market manipulation claim,” he said. The naked short selling was "not just a technical infraction” but was done to depress the price of a security, he added.
Chief Justice John G. Roberts asked why, then, the investors' complaint dived so deep into explaining federal securities laws on short selling if they weren’t relying on the regulations to prove their claims.
“We mention this in detail for a very specific reason,” Stris replied. “It has nothing to do with our theory of liability. It was us attempting to get in front of the inevitable preemption defense, which happens.”
Stris told Law360 he was pleased with how things went before the court. “The justices always ask tough questions, but I'm cautiously optimistic that they appreciate the importance of letting state courts decide state law cases,” he said.
Hacker did not immediately return a message seeking comment.
The investors are represented by Peter K. Stris, Brendan S. Maher, Daniel L. Geyser, Dana Berkowitz and Victor O’Connell of Stris & Maher LLP, Radha A. Pathak of Whittier Law School, Shaun P. Martin of the University of San Diego School of Law, Neal H. Flaster of the Law Offices of Neal H. Flaster and John A. Schepisi and Gregory M. Dexter of Schepisi & McLaughlin PA.
Merrill Lynch Pierce Fenner & Smith Inc. is represented by Thomas R. Curtin of Graham Curtin PA and Brad M. Elias, Andrew J. Frackman, Abby F. Rudzin, Walter Dellinger and Jonathan D. Hacker of O'Melveny & Myers LLP. Knight Capital Americas LP is represented by James H. Bilton, Edwin R. DeYoung and W. Scott Hastings of Locke Lord LLP. UBS Securities LLC is represented by Andrew B. Clubok and Beth A. Williams ofKirkland & Ellis LLP and William H. Trousdale and Brian M. English of Tompkins McGuire Wachenfeld & Barry LLP. National Financial Services LLC is represented by Michael G. Shannon of Thompson Hine LLP. Citadel Derivatives Group LLC is represented by Stephen J. Senderowitz, Steven L. Merouse and Jonathan S. Jemison of Dentons. E-Trade Capital Markets is represented by Kurt A. Kappes and David E. Sellinger ofGreenberg Traurig LLP.
The case is Merrill Lynch Pierce Fenner & Smith Inc. et al. v. Manning et al., case number 14-1132, in the Supreme Court of the United States.
--Editing by Brian Baresch.