On May 16, 2016, a unanimous Supreme Court held in Merrill Lynch v. Manning that certain securities-based state-law claims against Merrill Lynch and other financial institutions can proceed in state court rather than being mandatorily removed to federal court. The Manning decision will likely be seen as a victory for professional securities plaintiffs and their lawyers, who seek whenever possible to have their claims heard in state court rather than federal court. They do so because state courts and their juries are generally less skeptical of securities plaintiffs and, more importantly, because bringing actions in state court allows plaintiffs to avoid complying with the reforms enacted to protect defendants under the Private Securities Litigation Reform Act of 1995 (the “PSLRA”).
In Manning, the plaintiffs alleged that Merrill Lynch and the other defendants engaged in “naked” short selling that caused the stock of Escala Group, Inc. (“Escala”) to fall precipitously. The plaintiffs claimed that this naked short selling violated a number of New Jersey laws, including, improbably, its anti-racketeering statutes. Short selling is a trading strategy in which an investor commits to a future sale of stock it does not currently own at a set price with the expectation that it will be able to acquire the shares to cover its commitment at a lower price before the commitment becomes due. Short selling is not illegal, and it is used for a number of appropriate purposes, including hedging, providing liquidity and allowing investors to make money on a stock when they believe its price will fall. Naked short selling occurs when an investor commits to sell shares without having assurance that it will be able to obtain the shares in time to close the sale. Naked short selling is also not illegal, but the SEC’s Regulation SHO prohibits certain kinds of abusive naked short selling, such as intentionally failing to cover a short sale.
The Manning plaintiffs did not make a claim under Regulation SHO or any other provision of the federal securities laws and instead made only state law claims. Their complaint did, however, refer to certain unrelated violations of Regulation SHO that had been alleged against the defendants and suggested that their short sales of Escala’s shares also violated the rule.
Because the plaintiffs’ claims touched on Regulation SHO, the defendants removed the case to federal court on two grounds. First, they cited the general “federal question” statute, 28 USC §1331, which gives the federal district courts exclusive jurisdiction over actions “arising under” federal law. Second, they cited Section 27 of the Securities Exchange Act of 1934 (the “Exchange Act”), which gives the federal district courts exclusive jurisdiction over all suits and actions “brought to enforce any liability or duty created by” the Exchange Act or its rules.
In citing these provisions, the defendants argued that jurisdiction is exclusive to the federal courts any time a complaint alleges a violation of the federal securities laws, regardless of whether or not a claim is made under those laws. Plaintiffs, conversely, argued that the federal courts have exclusive jurisdiction only when the cause of action is “brought directly under the statute,” in other words, when the plaintiffs’ claims are expressly created by the federal securities laws.
The district court rejected the plaintiffs’ motion to remand the case to state court, but the Third Circuit reversed the district court’s decision, finding that there was no necessary connection between the plaintiffs’ claims and the federal securities laws. The Supreme Court affirmed the Third Circuit’s decision on a slightly different rationale.
As an initial matter, the Court held that, notwithstanding the different statutory language, the general federal question statute and Section 27 of the Exchange Act establish the same jurisdictional test and so are effectively coextensive in Exchange Act cases. The Court then held that the federal courts have exclusive jurisdiction over securities cases in two circumstances. First, as the plaintiffs argued, exclusive federal jurisdiction applies when the federal securities laws “create the cause of action asserted.” The Court also recognized a second “special and small category” of additional causes of action where exclusive federal jurisdiction applies: state-law claims that necessarily raise a “disputed and substantial” question of federal law that must be decided for the claim to succeed.
Manning constitutes a small victory for plaintiffs’ lawyers and their clients because it will allow them to bring some claims in state court that would not survive in federal court because of the requirements of the PSLRA. Using the state courts to avoid the PSLRA is not a new tactic, and in 1998 Congress adopted the Securities Litigation Uniform Standards Act (“SLUSA”), which, in essence, requires traditional, class action “strike suits” to be brought only in federal court and only under federal law, to prevent state-law end-runs around the PSLRA’s reforms. Manning, which was not a class action and did not include the issuer as a defendant, does nothing to undermine SLUSA, and public companies can take comfort in the fact that SLUSA will still require the overwhelming majority of securities law cases they are likely to face to be brought in federal court. Still, any victory for the securities plaintiffs’ bar is likely to encourage vexatious litigation against issuers of securities, and public companies should prepare themselves for an increase in such cases.