Does Section 27 of the Securities Exchange Act of 1934 give federal courts exclusive jurisdiction over state law claims based on violations of the Exchange Act, or may state courts hear those state law claims?
In this case, the Supreme Court will decide whether Section 27 of the Securities Exchange Act of 1934 (“Exchange Act”) provides federal courts with exclusive jurisdiction over state law claims based on violations of the Exchange Act or whether state courts are permitted to hear such state law claims. Merrill Lynch argues that Manning relies on Regulation SHO, a federal regulation, and therefore federal courts have exclusive jurisdiction under the Exchange Act. On the other hand, Manning argues that, because his claims are based on state law, state courts have jurisdiction over this case, even if some elements of his claim rely on federal law. Ultimately, the Court’s decision has the potential to affect whether uniformity in decision-making is necessary to enforce Regulation SHO and whether state courts can govern duties arising under federal regulations.
Questions as Framed for the Court by the Parties
Does Section 27 of the Securities Exchange Act of 1934 provide 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?
Greg Manning and others (hereinafter “Manning”), brought a lawsuit against Merrill Lynch Pierce Fenner & Smith, Inc., Knight Capital Americas L.P., UBS Securities LLC, E*TRADE Capital Markets LLC, National Financial Services LLC, Citadel Derivatives Group LLC, John Does 1-10, and ABC Companies (hereinafter “Merrill Lynch”) on May 8, 2012. Manning filed the initial lawsuit in the Superior Court of New Jersey alleging that Merrill Lynch had participated in “naked short selling” of Escala stock. During a short sale, a seller borrows securities from a buyer, sells those securities in the open market, and buys replacement securities to return to the broker. In a naked short sale, the seller does not return the securities to the buyer at the agreed time.
The selling allegedly increased the number of tradable shares available by “electronically manufacturing fictitious and unauthorized phantom shares.” Manning’s complaint alleges that the increase caused a decline in the value of the shares and diluted his voting rights.
Manning complaint against Merrill Lynch states two state-law causes of action and seeks relief under the New Jersey Racketeer Influenced and Corrupt Organizations Act (“RICO”). Additionally, Manning seeks relief on common law claims based on unjust enrichment, interference with economic advantage and contractual relations, breach of contract, breach of covenant of good faith and fair dealing, and negligence.
Under the federal Securities Exchange Act of 1934 ("Exchange Act"), Regulation SHO, 17 C.F.R. § 242.200 (“Regulation SHO”), participants in a short sale must reasonably believe that they can borrow and deliver securities within three days. Manning does not assert Regulation SHO as a cause of action; however, he mentions language mirroring Regulation SHO in his complaint. The complaint also mentions data used by broker-dealers in an effort to assist in complying with federal regulations. Merrill Lynch removed the case to the United States District Court of New Jersey because it believed that the issue of Regulation SHO provided federal courts with jurisdiction according to the principles of federal question jurisdiction.
Manning moved to have the case remanded to state court where the Magistrate Judge agreed with Manning’s argument, reasoning that Manning could win on either of his two state law causes of action, no longer needing to rely on federal law to obtain a judgment. The United States District Court of New Jersey, however, denied the remand.
Manning then appealed to the United States Court of Appeals for the Third Circuit, who also denied the remand. Manning then appealed to the United States Supreme Court, which granted certiorari on June 30, 2015 to determine the question of jurisdiction in this case.
In this case, the United State Supreme Court will decide whether federal courts hold exclusive jurisdiction over state law claims based on violations of Section 27 of the Securities Exchange Act of 1934 ("Exchange Act") or whether that jurisdiction is shared with state courts, thus permitting them to hear such claims. Merrill Lynch asserts that, because Manning’s complaint alleges violations of a federal regulation, the federal district court had exclusive jurisdiction under Section 27. Merrill Lynch argues that the plain language of Section 27 and Supreme Court precedent supports its reading that Section 27 grants exclusive jurisdiction to federal courts to hear claims alleging violations of the Exchange Act. Manning counters, asserting that his complaint alleges only state, not federal, claims and that state courts therefore have jurisdiction over this case. Manning maintains that Merrill Lynch misreads the language of Section 27 and that Court precedent has held that state courts have jurisdiction over state law-based claims, even if elements of those claims may turn on federal law.
DOES THE COMPLAINT ALLEGE VIOLATIONS OF A FEDERAL REGULATION OR ONLY A STATE LAW CLAIM?
Merrill Lynch contends that Manning’s complaint alleges violations of a federal law, specifically Regulation SHO, enacted by the Securities and Exchange Commission ("SEC"), as a basis to sue under state law. Merrill Lynch argues that by repeatedly asserting alleged violations of Regulation SHO, Manning’s complaint falls within the scope of Section 27 because it alleges violations of the Exchange Act and seeks to enforce the duties created by the Exchange Act. Merrill Lynch also asserts that Manning’s decision to enforce the Exchange Act by way of bringing state law claims, rather than solely federal claims, does not detract from the federal courts' exclusive jurisdiction, because Section 27 applies to all Exchange Act suits, regardless of whether a state law or federal law claim forms the basis for the complaint.
Manning counters that his complaint alleges only state law claims, based on regulations and duties created by the state of New Jersey, and that none of his claims turns on federal law. Manning asserts, contrary to Merrill Lynch’s view, that his complaint does not mention Regulation SHO at all and does not require him to prove any violation of Regulation SHO to recover on his state law-based claims. Manning also argues that a state law’s similarly to a federal one does not suggest that a suit brought to enforce the state law is also brought to enforce the federal law. Therefore, Manning argues that Section 27 jurisdiction does not apply to his claims because the Exchange Act did not create the claims.
DOES SECTION 27 GRANT EXCLUSIVE JURISDICTION TO FEDERAL COURTS?
Merrill Lynch argues that the express language of Section 27 grants federal courts exclusive jurisdiction over claims alleging violations of the Exchange Act or seeking to enforce duties under the Exchange Act. Merrill Lynch maintains that Congress frequently uses the phrase "shall have jurisdiction" only to create jurisdiction and that the phrase "shall have exclusive jurisdiction" therefore grants exclusive jurisdiction to the federal courts. Merrill Lynch asserts that its reading of the language of Section 27 reflects Congress's view that claims alleging violations of the Exchange Act are subject only to federal jurisdiction and not to state jurisdiction. Merrill Lynch also contends that the language of Section 27 does not grant jurisdiction to federal courts only if the alleged Exchange Act violations and duties are necessary elements of a complaint, but that the language grants exclusive jurisdiction to federal courts whenever the complaint asserts a violation or duty of the Exchange Act.
Manning argues that Merrill Lynch’s reading of Section 27 is too broad in that it would result in federal courts having exclusive jurisdiction over state law claims even if a plaintiff only vaguely alleges that at some point in time the defendant violated the Exchange Act. Manning also asserts that the language of Section 27 limits federal courts' jurisdiction to suits brought to enforce liabilities and duties created by the Exchange Act and therefore does not grant jurisdiction at all to federal courts over claims brought to enforce liabilities and duties created by state law. Manning further argues that Merrill Lynch incorrectly asserts that the plaintiff's complaint need only contain a violation or duty of the Exchange Act to obtain federal jurisdiction under Section 27. Manning maintains that traditional rules of federal jurisdiction require that state law claims must necessarily rely on a federal issue as their basis to create jurisdiction in the federal courts.
Merrill Lynch argues that Supreme Court precedent uniformly refers to Section 27 as granting exclusive federal jurisdiction. Merrill Lynch maintains that the Pan American Petroleum Corporation v. Superior Court of Delaware for New Castle County ("Pan American") decision, involving Section 22 of the Natural Gas Act which has the same jurisdictional language as Section 27 of the Exchange Act, held that exclusive federal jurisdiction turns on the type of claim alleged in the complaint. Merrill Lynch contends that, when making its decision in this case, the Third Circuit Court of Appeals misread Pan American to mean that an exclusive jurisdiction provision never creates federal jurisdiction on its own. Merrill Lynch, however, asserts that Pan American merely requires that federal courts already have jurisdiction over a complaint from the start in order for that jurisdiction to be exclusive under an exclusive jurisdiction provision, such as the ones found in Section 27 of the Exchange Act and Section 22 of the Natural Gas Act.
Manning argues that, contrary to Merrill Lynch’s analysis, Supreme Court precedent supports the reading of Section 27 that would retain state court jurisdiction. Manning contends that in Matsushita Electric Industrial Co. v. Epstein ("Matsushita"), the Court held that the state court retained jurisdiction over a state law claim alleging that the defendant had exposed a corporation to liability under the Exchange Act, despite the fact that one of the state law claims was based on a federal allegation. As a result, Manning asserts that Court precedent supports the interpretation that federal jurisdiction does not arise when a plaintiff brings suit to enforce state law claims, even if aspects of those claims rely on federal law. Finally, Manning argues that Merrill Lynch misreads the Pan American decision and that the decision concludes that the exclusive jurisdiction provision does not grant any additional jurisdiction beyond what federal courts are already granted under existing statutes.
The Supreme Court will decide whether Section 27 of the Securities Exchange Act of 1934 ("Exchange Act") gives federal courts exclusive jurisdiction over state law claims based on violations of the Exchange Act. Merrill Lynch argues that Manning relies on a federal regulation, and that federal courts have exclusive jurisdiction under Section 27. Manning argues that his claim is based on state law; and, therefore, state courts have jurisdiction even if they rely partly on federal law. The Court’s decision in this case may determine whether uniformity of decisions is necessary to enforce a federal regulation, such as Regulation SHO, that deals with financial markets, and whether state courts can govern such duties arising from federal regulations.
UNIFORMITY OF DECISIONS NECESSARY TO ENFORCE REGULATION SHO
The Chamber of Commerce of the United States of America (“The Chamber”), in support of Merrill Lynch, argues that the Securities Exchange Act of 1934 was intended to regulate financial markets. The Chamber argues that "centralization and standardization" are necessary to the regulation of financial markets. The Chamber adds that the state court would create variation in decisions regarding federal regulations, such as Regulation SHO, if it fails to apply federal law. The Securities Industry and Financial Markets Association (“SIFMA”), also in support of Merrill Lynch, agrees with the Chamber, arguing that uncertainty regarding whether state or federal law should apply would deter investors from participating in short sales. SIFMA asserts that uniformity would allow greater risk taking and participation in the market and would therefore further the goal of the Exchange Act to maintain open markets.
Manning counters by arguing that, while uniformity is important, Congress did not intend for uniformity to be achieved via federal courts in enforcing state claims regarding Regulation SHO. Manning asserts that Congress, in giving state courts the ability to hear cases that have an overlap of state claims and federally imposed duties, balances federal and state interests.Furthermore, Manning claims that because federal causes of action asserting federal regulation violations will be heard in federal courts, state courts will have a body of law to rely on when making decisions on claims based on state law. State courts will therefore, according to Manning, be able to enforce Regulation SHO effectively.
SHOULD STATE OR FEDERAL COURTS GOVERN DUTIES ARISING FROM FEDERAL REGULATIONS?
The Chamber argues that the duties Manning is attempting to enforce stem from the Exchange Act. The Chamber argues that courts should rely on Congress’ intent to consider the underlying violation rather than look solely at whether the claim is based on state law or federal law. According to the Chamber, the underlying violation in this case is based on Regulation SHO and, therefore, should be governed by federal law. Nasdaq, Inc., et al., in support of Merrill Lynch, argues that the underlying violation in this case should be removed to federal court, specifically asserting that a state claim to enforce an underlying violation of the National Association of Securities Dealers may be brought in federal court under Section 27 of the Exchange Act.
Manning argues that, because the lawsuit can be brought under state law, the duties being enforced arise under state law independent of the fact that similar duties exist under federal statutes. In other words, according to Manning, the existence of a state law cause of action necessitates state rights, duties, and remedies. Manning claims that the similarities between state rights, duties, and remedies and federal rights, duties, and remedies do not automatically allow federal law to govern. Therefore, according to Manning, even though it appears that the violation involves federally imposed duties, the violation actually involves state imposed duties and the case should remain in state court.
The Supreme Court's decision in this case will determine whether Section 27 of the Securities and Exchange Act ("Exchange Act") grants exclusive jurisdiction to federal courts over state law claims brought for violations of or to enforce duties under the Exchange Act. asserts that federal district courts have exclusive jurisdiction over Manning’s state law claim based on violations of federal law. Manning counters, arguing that his complaint alleges only state law claims and that Section 27 does not provide exclusive federal jurisdiction over those claims. This decision may ultimately affect the uniformity of decisions regarding claims alleging violations of the Exchange Act and whether state courts can retain jurisdiction over federal regulation claims.
- Ben Conarck, Merrill Lynch Blasted for High Court Bid in Short-Selling Suit, Law360 (June 12, 2015).
- Matthew Tobin & Zachary Ziliak, The High Court's Key Jurisdiction Question in Manning, Law360 (Sept. 1, 2015).