The Supreme Court Outlines Test For “Blue Sky” Jurisdictional Issues

On Monday, May 16, 2016, the United States Supreme Court issued a majority decision in Merrill Lynch, Pierce, Fenner & Smith v. Manning, No. 14-1132, 2016 U.S. LEXIS 3049 (U.S. May 16, 2016), affirming a Third Circuit Court of Appeals decision which remanded the plaintiff’s state securities law (or “Blue Sky”) claims back to New Jersey state court.  Justice Clarence Thomas delivered a concurring opinion, joined by Justice Sonia Sotomayor, which agreed with the majority opinion’s result, but not its method.

Plaintiff, Manning, alleged that defendant, Merrill Lynch, violated New Jersey law by engaging in “naked” short sales to manipulate stock prices, causing him to lose most of his investment.  In contrast to typical short sales, “naked” short sales occur when the seller does not borrow stock, but sells shares anyway which results in the promised shares never being actually delivered to the buyer.  In addition to the plaintiff’s state law claims, the complaint referred explicitly to Regulation SHO (17 C.F.R. §§ 242.200-204), issued by the Securities and Exchange Commission under the federal Securities and Exchange Act of 1934 (the “Exchange Act”), and which prohibits the intentional failure to deliver securities.  Significantly, plaintiff’s state-law claims did not necessarily require him to establish a violation of that regulation.  At issue in Merrill Lynch was whether Section 27 of the Exchange Act limited plaintiff’s lawsuit to a federal forum.

Section 27 of the Exchange Act grants federal courts “exclusive jurisdiction of . . . all suits in equity and actions at law brought to enforce any liability or duty created by this title [15 U.S.C. §§ 78a et seq.] or the rules and regulations thereunder.”  15 U.S.C. § 78aa(a) (emphasis added).  To interpret the meaning of “to enforce,” the majority borrowed from case law interpreting a different statute, 28 U.S.C. § 1331, which grants federal courts jurisdiction over claims “arising under” federal law.  The majority found that a state-law claim which “necessarily depends on a showing that the defendant breached the Exchange Act . . . fall[s] within § 27’s compass.”  Merrill Lynch, 2016 U.S. LEXIS 3049, at *14.  

The defendant argued that proper construction requires application of Section 27 if a complaint “either explicitly or implicitly ‘assert[s]’ that ‘the defendant breached an Exchange Act duty.’”  Id. at *11.  The majority disagreed, noting that,

a natural reading of § 27’s text does not extend so far.  ‘Brought’ in this context means ‘commenced,’ Black’s Law Dictionary 254 (3d ed. 1933); ‘to’ is a word ‘expressing purpose [or] consequence,’ The Concise Oxford Dictionary 1288 (1931); and ‘enforce’ means ‘give force [or] effect to,’ 1 Webster’s New International Dictionary of the English Language 725 (1927).  So § 27 confers federal jurisdiction when an action is commenced in order to give effect to an Exchange Act requirement.  That language, in emphasizing what the suit is designed to accomplish, stops short of embracing any complaint that happens to mention a duty established by the Exchange Act.

Id. at *11-12 (emphasis added).  

The majority also rejected plaintiff’s interpretation, that “a suit is brought to enforce the Exchange Act’s duties or liabilities only if it is brought directly under that statute.”  Id. at *13.  Under plaintiff’s construction, a state statute “which makes illegal ‘any violation of the Exchange Act involving naked short selling’” would not fall within Section 27 even though the plaintiff “must undertake to prove, as the cornerstone of his suit, that the defendant infringed a requirement of the federal statute.”  Id. at *14.

To determine whether a state law claim “necessarily depends” on an Exchange Act duty, the majority adopted the jurisdictional test under 28 U.S.C. § 1331.  Summarizing this test, the majority explained “a federal court has jurisdiction of a state-law claim if it necessarily raise[s] 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.”  Id. at *15.  The Merrill Lynch majority concludes by holding that “Section 27 provides exclusive federal jurisdiction of the same class of cases as ‘arise under’ the Exchange Act for purposes of § 1331.”  Id. at *29 (emphasis added).  This “require[d] remanding Manning’s suit to state court.”  Id.

The concurring opinion posited a different method in coming to the same conclusion.  Specifically, the concurrence “rest[ed] [its] conclusion [solely] on the statute before [it], § 27 of the Securities Exchange Act of 1934, 15 U.S.C. § 78aa(a).”  Id. at *30.  The concurrence cautioned that relying on § 1331 jurisprudence, which requires courts to consider “a substantiality requirement and a federal-state balance requirement[,] . . . risks narrowing the class of cases that Congress meant to cover with § 27’s plain text.”  Id. at *38.  The concurrence, therefore, affixed the entirety of its analysis to the plain text of Section 27, concluding that the statute “confers jurisdiction if the complaint alleges claims that necessarily depend on establishing a breach of an Exchange Act requirement.”  Id. at *33.  Applying this rule, the concurrence concluded that “vindicating [plaintiff’s state-law] claim would not require the enforcement of a federal duty or liability” and, therefore, his claims “d[id] not necessarily depend on the breach of an Exchange Act duty or liability.”  Id. at *35.

After Merrill Lynch, courts will resolve Section 27 jurisdictional disputes utilizing traditional 28 U.S.C. § 1331 jurisprudence.