Supreme Court to Decide if “Naked” Short Selling State Law Claim May Be Resolved in State Court

The issue in Merrill Lynch v. Manning is whether state law claims alleging that the “naked” short selling at issue in this case violated state law must be heard in federal court.

In a short sale, a short seller identifies a security he or she believes will decline in value, borrows some of those securities from a broker and sells them. When the securities decline in value he or she rebuys them and makes a profit.

In a “naked” short sale the seller doesn’t borrow the securities in time to deliver them to the buyer—to manipulate the security’s price or to avoid borrowing costs. While “naked” short selling isn’t per se illegal under federal law, some schemes may violate federal antifraud law and Security and Exchange Commission (SEC) rules.

The plaintiff-shareholders in this case want to sue Merrill Lynch in state court for engaging in “naked” short selling which they claim violated New Jersey general securities fraud law, which is not as detailed as SEC regulation of “naked” short selling.

Section 27 of the Securities Exchange Act gives federal district courts “exclusive jurisdiction” of all lawsuits to enforce the Exchange Act. Merrill Lynch argues that even though the plaintiffs in this case are alleging violations of New Jersey law their claim should be heard in federal court.

The Third Circuit disagreed applying Pan American Petroleum Corp. v. Superior Court of Delaware In & For New Castle County (1961), where the Supreme Court considered an exclusive jurisdiction provision of the Natural Gas Act, “substantially identical” to Section 27 of the Securities Exchange Act.  In Pan American the Court held that “’Exclusive jurisdiction’ is given the federal courts but it is ‘exclusive’ only for suits that may be brought in the federal courts. Exclusiveness is a consequence of having jurisdiction, not the generator of jurisdiction.” State court jurisdiction exists in this case because federal law doesn’t have to be applied to decide it as plaintiffs are suing exclusively under New Jersey law. Even if New Jersey law isn’t as “robust” as federal law it is for the state court to decide if state law applies.

The Supreme Court likely agreed to decide this case because of a circuit split on this issue between the Third and the Second Circuits and the Fifth and Ninth Circuits.