In Merrill Lynch, Pierce, Fenner & Smith Inc. v. Manning, the U.S. Supreme Court held that mere references to Securities Exchange Act of 1934 violations in a state law claim filed in state court are not sufficient grounds for removal to a federal court.

In Merrill Lynch, Pierce, Fenner & Smith Inc. v. Manning, 136 S. Ct. 1562 (2016), the U.S. Supreme Court held that Section 27 of the Securities Exchange Act of 1934 (Exchange Act) does not provide exclusive federal jurisdiction over claims asserted under state law, even if the claims allege conduct that would violate the Exchange Act or regulations adopted under the Exchange Act. The Court held that to exercise exclusive federal jurisdiction under Section 27 of the Exchange Act, a claim must be analyzed under the classic “arises under” test as applied to general federal law for purposes of 28 U.S.C. §1331. Therefore, a federal court may exercise exclusive jurisdiction under Section 27 only if a claim specifically seeks relief under the Exchange Act or if a state law claim rises or falls on proof of a violation of the Exchange Act. Merely referencing federal laws and regulations will not suffice for removal of a state law claim to a federal court.

The Manning Saga

In Manning, seven shareholders of the Escala Group, Inc. (collectively, Manning) filed suit in New Jersey state court alleging that Merrill Lynch, Pierce, Fenner & Smith Inc. and other financial institutions (collectively, Merrill Lynch) engaged in “naked short sales” of stock, in violation of New Jersey law. In a typical short sale, an investor borrows stock from a broker, sells it to a buyer on the open market, and later purchases the same number of shares to return to the broker. But the seller in a “naked short sale” neither owns nor intends to borrow the stock the seller puts on the market, and accordingly does not deliver the shares to a buyer. This practice is regulated by Regulation SHO as implemented by the Securities and Exchange Commission. Regulation SHO prohibits short sellers from intentionally failing to deliver securities, thereby curbing market manipulation.

Manning alleged that Merrill Lynch’s conduct violated provisions of the New Jersey Racketeer Influenced and Corrupt Organizations Act (RICO), New Jersey Criminal Code, and New Jersey Uniform Securities Law. Notably, Manning did not bring any claims under the federal securities laws or regulations. Manning did, however, explicitly refer to Regulation SHO by “describing the purposes of [the] rule and cataloguing past accusations against Merrill Lynch for flouting its requirements” thereby suggesting that Merrill Lynch had once again violated Regulation SHO.

Merrill Lynch removed the case to federal district court, and Manning unsuccessfully moved to remand the case back to state court. On appeal, the Third Circuit reversed and remanded the case back to state court, reasoning that the claims were “brought under state law” and did not “necessarily raise” a federal issue.

The Supreme Court Decision

Merrill Lynch argued for an expansive interpretation of Section 27, reasoning that Section 27 requires a federal court to exercise jurisdiction over “any suit that either explicitly or implicitly asserts a breach of an Exchange Act duty….even if the plaintiff seeks relief solely under state law.” On the other hand, Manning argued that Section 27 requires a federal court to exercise jurisdiction only if the complaint alleges a cause of action under the Exchange Act or under a regulation issued under the Exchange Act.

The Court declined to adopt either argument, instead choosing a middle path. The Court held that there are two instances in which a federal court can exercise exclusive jurisdiction: (1) where the federal law creates the “cause of action asserted” and (2) where “a state-law claim ‘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.’” Therefore, a federal court can exercise jurisdiction over claims alleging violations of the Exchange Act or its implementing regulations when either the Exchange Act creates a cause of action or a state-law claim rises or falls on proof that an Exchange Act duty was violated.

Potential Impact of the Decision

The Manning decision will disappoint those in the defense bar who had hoped the Court would make it easier for defendants to remove actions like this to federal court. But their disappointment aside, the decision will have limited impact because the Securities Litigation Uniform Standards Act of 1998 already requires that many misrepresentation-based class claims based on state securities laws be dismissed or pursued (if at all) in federal court. And this is just one battle in a broader 20-year war over where securities cases get litigated. Just last week some litigants petitioned the U.S. Supreme Court to decide whether state courts have jurisdiction to adjudicate claims under the Securities Act of 1933, an issue on which scores of U.S. District Courts have split. So the fight goes on. Stay tuned.