Short-Sale Dispute Belongs in N.J. Court, Justices Say

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By Phyllis Diamond

May 12 — Investors who sued a group of broker-dealer firms under New Jersey state law for allegedly engaging in a naked-short selling manipulation scheme may continue their suit in New Jersey state court where the claims were filed, the U.S. Supreme Court ruled May 16.

The fact that the alleged misconduct could run afoul of 1934 Securities Exchange Act Regulation SHO doesn't give rise to exclusive federal jurisdiction over the controversy, Justice Elena Kagan wrote.

The court disagreed with the defendant broker-dealer firms' argument that the investors were seeking to enforce a duty created by Reg SHO, even though they didn't allege a Reg SHO violation.

Siding with the investors, it said the case belongs in New Jersey state court, as the U.S. Court of Appeals for the Third Circuit concluded (218 SLD, 11/12/14).

Justice Clarence Thomas, joined by Justice Sotomayor, concurred in the judgment.

Naked short selling generally refers to a sale of securities when the seller doesn't own the securities sold and makes no arrangement to borrow the securities in order to make delivery on the sale.

In this case, a group of Escala Group Inc. shareholders alleged in New Jersey state court that the defendant investment banks engaged in naked short-selling to manipulate the market price of Escala securities. Their complaint set out 10 causes of action, all under New Jersey law. The investment banks—Merrill Lynch Pierce Fenner & Smith, Inc.; Knight Capital Americas, a/k/a Knight Equity Markets L.P.; UBS Securities LLC; E Trade Capital Markets LLC; National Financial Services LLC; and Citadel Derivatives Group LLC— removed the lawsuit to federal district court, which in turn certified an appeal to the U.S. Court of Appeals for the Third Circuit to decide whether remand was appropriate.

In November 2014, the appeals court concluded that it didn't have federal-question jurisdiction under 28 U.S.C. Section 1331(218 SLD, 11/12/14). It also held that '34 Act Section 27, which provides exclusive federal jurisdiction of lawsuits “`brought to enforce'” any duty or liability “`created by'” the statute, didn't provide an independent basis to exercise jurisdiction over the allegations.

In March 2015, the broker-dealer firms asked the high court to decide whether Section 27 requires the lawsuit to be brought in federal court (56 SLD, 3/24/15). In June, the justices agreed to review the decision (126 SLD, 7/1/15).

Same Suits

Affirming, the high court said that like the Third Circuit, it reads Section 27 as conferring exclusive federal jurisdiction over the same suits as those “`aris[e] under'” the Exchange Act for Section 1331 purposes. Merrill Lynch argued that when claims allege—explicitly or implicitly—the breach of a '34 Act duty, the lawsuit is “`brought to enforce'” that duty, but the justices didn't agree.

In this context, Kagan wrote, “brought” means the same thing as “commenced.” It doesn't encompass any claim that, as in this case, “happens to mention a duty established by the Exchange Act.”

Thomas, Sotomayor Concurrence

Thomas agreed that the lawsuit belongs in state court but based his conclusion on Section 27, which he said doesn't use the words “`arising under' or provide a sound basis for adopting the arising under standard.”

The complaint in this case doesn't allege a claim that necessarily depends on the breach of a '34 Act requirement and should be returned to New Jersey state court, he concluded.

Moderate Approach

At least one observer doesn't think the case will have much of an impact. According to Georgetown University Law Professor Donald Langevoort, the justices took “a very moderate approach to what kinds of state law cases are removable.”

In fact, he told Bloomberg BNA in an e-mail, the main distinction between the majority and the concurring justices involves how to read the statute, not what the preferred reading ultimately says.

Essentially, Langevoort wrote, the court is expressing “respect for state law when the language of the federal statute in question doesn't clearly remove jurisdiction or operate to preempt.”

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