by T. GormanPosted on Posted in SECActions

Exchange Act Section 27 gives federal district courts exclusive jurisdiction of all suits “brought to enforce any liability or duty created” by the Act. The critical question was the scope and reach of that exclusive jurisdiction. The issue had split the circuit courts. Viewing the question as one of whether the suit “arises under” federal law, the Supreme Court concluded that the third circuit had properly reversed a lower court determination that the suit could be removed from state court. Merrill Lynch, Pierce, Fenner & Smith Inc. v. Manning, No. 14-1132 (S.Ct. Decided May 16, 2016).

This suit centers on a short selling claim. Respondent Greg Manning held over two million shares of Escala Group, Inc. The shares are traded on NASDAQ. Between 2006 and 2007 the share price plummeted. The investment lost most of its value.

Mr. Manning claimed that the share price dropped because of naked short selling by Merrill Lynch and other financial institutions. In his complaint, Mr. Manning and several other Escala shareholders alleged that Merrill Lynch facilitated and engaged in naked short sales of the stock in violation of New Jersey law. Specifically, the complaint claims that the failure to deliver and cover the short positions violated the New Jersey RICO statue, criminal code, securities law and common law. No claim was bought under federal law. The complaint does note that Exchange Act Regulation SHO governs short selling and prohibits failures to deliver.

Merrill Lynch removed the complaint to federal district court. That court denied Mr. Manning’s request for remand. The third circuit reversed. The Supreme Court affirmed.

Justice Kagan, writing for six members of the Court, began with the text of Section 27 which clearly gives federal district court’s exclusive jurisdiction. Merrill Lynch argued that grant of exclusive grant of jurisdiction should be read expansively to cover any suit that either explicitly or implicitly asserts the breach of an Exchange Act duty. Mr. Manning proposed a far more restrictive interpretation. In his view, Section 27 only covers suits that are brought to vindicate a claim actually created by the Exchange Act. The text, the Court concluded, “more readily” supports the interpretation that the exclusive jurisdiction applies to suits “arising under” the Exchange Act, a phrase found in the general federal question statute, 28 U.S. C. § 1331. Indeed, the Court’s “precedents interpreting identical statutory language positively compel that conclusion.”

There is no doubt that as Mr. Manning contends, a complaint which asserts a right of action deriving from the Exchange Act, or one of its regulations, must proceed in federal court. While Merrill Lynch “veers too far,” if a state-law action necessarily “depends on a showing that the defendant breached the Exchange Act, then that suit could also fall within § 27 as it contends. The existing jurisdictional test of “arising under” captures both of these prospects: “This Court has found that statutory term satisfied in either of two circumstances. Most directly, and most often, federal jurisdiction attaches when the federal law creates the cause of action asserted . . . [and] As this Court has explained, a federal court has jurisdiction of a state-law claim if it necessarily raises a stated federal issue, actually disputed and substantial, which a federal forum may entertain without disturbing any congressionally approved balance of federal and state power.” (internal quotations and citations omitted). This is the situation here.

The Court has reached the same conclusion before. In Pan American Petroleum Corp. v. Superior Court of Del. for New Castle City, 366 U.S. 656 (1961) when construing § 22 of the Natural Gas Act – an exclusive jurisdiction Section with the same language as here – the Court concluded that the phrase “brought to enforce” should be construed using the “arising under” test. Similarly, in Matsushita Elec. Industrial Co. v. Epstein, 516 U.S 367 (1996) which “addressed § 27 itself . . [the Court] once again equated the ‘brought to enforce’ and ‘arising under’ standards. That decision arose from a state-law action against corporate directors for breach of fiduciary duty. The issue was whether the state court handling the suit could approve a settlement releasing, in addition to the state claims actually brought, potential Exchange Act claims that § 27 would have committed to federal court.” Matsushita held that it could, interpreting the Section using the “arising under” test.

Finally, construing §27 in accord with its text and prior precedent “gives due deference to the important role of state courts in our federal system. . . Out of respect for state courts, this Court has time and again declined to construe federal jurisdictional statutes more expansively than their language, most fairly read, requires. We have reiterated the need to give due regard to the rightful independence of state governments – and more particularly, to the power of the States to provide for the determination of controversies in their courts. “ (internal quotations and citations omitted).

Justice Thomas filed a concurring opinion joined by Justice Sotomayor.

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by T. GormanPosted on Posted in SECActions

Two attorneys, with fiduciary duties to their clients by virtue of their role as escrow agents, served not as the protector of client funds, but enablers of a fraudulent scheme. The plot was uncovered by OCIE during an inspection of a broker-dealer being used to trade the client investment money. SEC v. Rust, Civil Action No. 1:16-cv-03573 (S.D.N.Y. Filed May 13, 2016).

Defendants Jay Rust and Christopher Brenner are attorneys licensed to practice law in the State of Texas. Atlantic Rim Funding is the alter ego of Individual X, a person currently serving a 20 year term in a California prison for securities fraud unrelated to this action.

Attorney Rust was recruited by Individual X in November 2011to serve as an escrow agent for a commercial lending program with Atlantic. Previously, Mr. Rust had served as an escrow agent for Individual X, that person’s wife, and others on another matter. Individual X was sued in that matter by investors. Those investors claimed he failed to honor his commitments. Mr. Rust was aware of the suit.

The new program through Atlantic called for would-be borrowers to deposit cash amounting to ten percent of an anticipated loan. Those funds would then be leveraged to secure a loan ten times the amount of the deposit, according to the sale pitch.

The participation of Attorney Rust was important to investor confidence, Individual X explained. Indeed, part of Mr. Rust’s function was to assure investors that he would serve as the escrow agent on their behalf, protecting their deposits, the securities purchased with their cash and the loan proceeds. Investors were not told that Attorney Rust entered into an agreement with Individual X which entitled him to any interest from the deposit of their funds as well as 3% of Atlantic’s profits from all amounts in trade associated with any collateral or funds generated by his services. That amount would be a minimum of $15,000 per month up to a maximum of $100,000 per month.

Beginning in December 2010, and continuing for over the next year and one half, Mr. Rust solicited thirteen small business owners. They deposited about $8.5 million with Attorney Rust as their escrow agent. Each investor execute an agreement which assured them regarding the safety of the escrow, that there would only be nominal handling fees and that investments would be in government backed securities or instruments.

Those representations were materially misleading. In fact Mr. Rust opened a brokerage account, claiming that the source of funds would be “business/self-employment.” The investor funds were not put in government securities but others. Eventually Mr. Rust misappropriated portions of the funds and, when he could not repay investors as required, began using new investor funds to repay earlier ones.

In early August 2011 Individual X replaced Attorney Rust with Attorney Brenner. He had a prior experience with Atlantic – Mr. Brenner was representing an Atlantic client who had deposited $500,000 in July 2011 through Mr. Rust and had not received any loan funds.

Nevertheless, Mr. Brenner agreed to serve as escrow agent for the same lending program that Mr. Rust had touted. Mr. Brenner understood, according to the complaint, that his role was essentially the same as that of Mr. Rust – to induce investor participation with assurances of safety and security. From September 2011 through March 2012 he did just that, securing 15 new clients for the scheme who put up $3.4 million. The results for those clients were the same as for those recruited by Mr. Rust – the funds were not invested as represented, portions were misappropriated and eventually new investor funds repaid prior investors. The complaint alleges violations of Exchange Act Section 10(b). The case is pending.

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