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From Securities Regulation Daily, November 10, 2014

Claims resembling Reg SHO violations do not “necessarily” raise federal issues

By Amy Leisinger, J.D.

A Third Circuit panel has reversed a district court’s decision to retain jurisdiction over a case involving fraudulent “naked” short selling brought under New Jersey law. On interlocutory appeal, the panel found that, despite similarity to claims under the SEC’s Regulation SHO, none of the plaintiffs’ allegations “necessarily” invoked federal law as necessary to find federal-question jurisdiction. The panel directed the district court to remand the case to New Jersey state court (Manning v. Merrill Lynch Pierce Fenner & Smith, Inc., November 10, 2014, Smith, D.).

Background. Shareholders in Escala Group, Inc. filed a complaint in the Superior Court of New Jersey against several financial institutions alleging that they participated in “naked” short selling of Escala stock, which caused dilution of their voting rights and losses in share value. In the complaint, the plaintiffs pleaded several causes of action under New Jersey law, including: (1) claims under the New Jersey Racketeer Influenced and Corrupt Organizations (RICO) Act; and (2) common law claims for unjust enrichment and breach of contract, among others.

“Naked” short selling is not specifically illegal under federal law, but some activities may violate Regulation SHO, which imposes certain requirements on broker-dealers in order to prevent fails to deliver in connection with short selling. Noting that there is no New Jersey equivalent to Regulation SHO, the defendants removed the action from state court to the New Jersey federal district court based on federal question jurisdiction. The district court found remand inappropriate, noting that the case is premised on an alleged violation of a federal Exchange Act regulation, but certified the issues for an interlocutory appeal.

Federal jurisdiction. The defendants argued that removal was appropriate, citing two federal statutory provisions that confer jurisdiction: (1) Section 1331 of the United States Code, which gives district courts original jurisdiction over actions arising under the laws of the United States; and (2) Exchange Section 27, which gives district courts “exclusive jurisdiction” over actions brought to enforce a provision of, or rule under, the Exchange Act. The court rejected this argument, noting that, to permit jurisdiction under Section 1331, an action must “necessarily raise” an issue requiring a federal-law determination as an essential element of the claim. “The question of whether the naked short selling at issue in this case violates New Jersey law … need not be answered by reference to Regulation SHO,” according to the panel, and the plaintiff’s success on their state-law claims will not “necessarily” depend on federal law. Moreover, the panel found that the Exchange Act’s “exclusive jurisdiction” provision “cannot independently generate jurisdiction.” As the plaintiffs’ claims could be resolved based entirely on New Jersey law, the panel remanded the case to the district court with the instruction to remand it to the Superior Court of New Jersey.

The case is No. 13-3693.

Attorneys: Neal H. Flaster (Neal H. Flaster, L.L.C.) for Greg Manning and Londrina Holding Limited. Brad M. Elias (O'Melveny & Myers LLP) for Merrill Lynch Pierce Fenner Smith Inc. James H. Bilton (Locke Lord LLP) for Knight Capital Americas, a/k/a Knight Equity Markets. Andrew B. Clubok (Kirkland and Ellis LLP), Brian M. English, I (Tompkins, McGuire, Wachenfeld & Barry) for UBS Securities. Rebecca Brazzano (Thompson Hine) for National Financial Services LLC. Melissa S. Bogad (Winston & Strawn LLP) for Citadel Derivatives. Kurt A. Kappes (Greenberg Traurig, LLP) for E Trade Capital Markets.

Companies: Londrina Holding Limited; Merrill Lynch Pierce Fenner Smith Inc.; Knight Capital Americas, a/k/a Knight Equity Markets; UBS Securities; National Financial Services LLC; Citadel Derivatives; E Trade Capital Markets

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