Naked short selling is an illegal practice of trading stocks before you actually take possession of the stock or before determining if they even exist. Ordinarily, stock traders must borrow a stock, or determine that it can be borrowed, before they sell it short. This practice wreaks havoc on market prices because it artificially adds units to supply/demand issues and can obscure the true price of a security. The U.S. Supreme Court recently agreed to hear the case of Merrill Lynch Pierce Fenner & Smith Inc. v. Manning, concerning this illegal practice. However, this case is likely to have far-reaching implications beyond just the practice of short-selling. At issue is whether some state laws can be used to deter illegal stock trading or whether the only remedy is under federal law. As readers of this newsletter will recognize, this issue is commonly referred to as “federal preemption.” Unfortunately, when Courts start expanding federal preemption rights, consumers usually lose out.
The Plaintiffs in this case filed suit in May 2012, accusing Merrill Lynch, UBS Securities LLC and other firms of illegally shorting a company’s stock by entering sell orders for shares they did not own or did not reasonably believe they could borrow, and then profiting amid the collapse in that company’s share price. While short selling is regulated under the federal law, the Plaintiffs filed suit in the New Jersey Superior Court by alleging violations of the state’s Racketeer Influenced and Corrupt Organizations (RICO) Act and its Uniform Securities Law. The case was removed to federal district court, where it remained until the Third Circuit issued its ruling in November. The appellate court said the question of whether the short selling at the heart of the case violated state law could be answered without referring to federal regulations.
In Manning, the Court has the opportunity to establish the extent to which federal securities laws preempt certain state-based claims. The question before the justices is whether a section of the Securities Exchange Act of 1934 creates federal jurisdiction over state court claims that seek to establish liability for violations of state laws based on a violation of the federal law. Merrill Lynch and the other firms contend that the act does create federal jurisdiction. They claim that the Third Circuit was wrong when it sent the shareholder lawsuit back to the New Jersey state court where it began three years ago.
There is a split of opinion between the different circuit courts of appeal on this issue. Merrill Lynch argued that the Third Circuit, like the Second Circuit before it, ruled in a manner that directly conflicted with holdings of the Fifth and Ninth circuits. The split is over whether Section 27 of the Exchange Act creates federal jurisdiction over state-based claims. In remanding the shareholder suit back to state court, the federal appeals court said it does not, unless there is another, independent basis for federal jurisdiction.
On the other hand, the appellate claim that the Fifth and Ninth circuits have held the section confers jurisdiction only on federal courts over all actions that seek to establish liability based on the violations of the Exchange Act. The Supreme Court has the opportunity to clear things up on the issue.
The appellants petitioned the U.S. Supreme Court in March, calling their case the “ideal vehicle” for resolving the circuit split. They further warned that if the Third Circuit’s ruling is left standing, it would seriously disrupt the objective of having a uniform national regulatory system over the securities sector and would effectively empower 51 different state court systems to enforce and interpret the Exchange Act.
It will be interesting to see if the justices will move toward more federal preemption of state securities claims. While there has been lots of speculation over what the high court may do, nobody really knows. The court may not be concerned about state courts deciding matters of securities law. In any event, however, the court will likely clear up the split in the circuits.
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