Supreme Court: The Reach of Exchange Act Section 27

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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