On May 16, 2016, the U.S. Supreme Court held pleadings that exclusively allege a violation of state securities laws are allowed to proceed in state court so long as they do not “arise under” the Securities and Exchange Act of 1934, even where the complaint explicitly references federal securities regulations. Merrill Lynch, et al. v. Manning et al., 578 U.S. ____ (2016)
The Merrill Lynch case stems out of allegations by an Escala Group, Inc., stockholder that Merrill Lynch devalued Escala stock by executing “naked short sales”—a type of short sale prohibited under Regulation SHO of the Exchange Act. Plaintiff Greg Manning sued Merrill Lynch, alleging that its naked short sales of Escala stock violated certain New Jersey state laws, and seeking damages for his stock losses. Although Mr. Manning did not allege any federal securities violations, he did make reference to Regulation SHO—and Merrill Lynch’s history of noncompliance with it—in his complaint. Merrill Lynch removed the case to federal court under Section 27 of the Exchange Act, 15 U.S.C. § 78aa(a). Manning moved to remand. The district court denied Manning’s motion, and the Third Circuit reversed.
In granting certiorari, the Supreme Court solely took up the question of the standard for conferring federal jurisdiction under Section 27. Writing for the majority, Justice Kagan noted the Court found that the Section 27 analysis should mirror the analysis applied in all federal question cases under 28 U.S.C. § 1331. The Court therefore held that Section 27 confers exclusive federal jurisdiction where a case “’aris[es] under’ the Exchange Act . . . .” As with Section 1331, federal jurisdiction attaches (1) where federal law creates the cause of action asserted or (2) where the state law claim “’necessarily raise[s] a stated federal issue . . . .” Accordingly, cases that assert state law causes of action that simply seek to enforce a duty created by the Exchange Act will still end up in federal court.
Applying the “arises under” analysis to Section 27, the Court found that the district court lacked jurisdiction over Manning’s claims because he merely made reference to past violations of Regulation SHO, and asserted unique violations of New Jersey state law. The Court affirmed the decision of the Third Circuit remanding the case to state court.
The practical takeaway from the Merrill Lynch decision is that Section 27 is to be construed just like Section 1331. Cases that “arise under” the Exchange Act belong in federal court, while cases alleging unique state law causes of action that do not depend on a predicate violation of an Exchange Act duty will be permitted to proceed in state court.
Adam E. Polk is an associate with Girard Gibbs LLC in San Francisco, California.