Commercial Litigation and Arbitration

Federal Jurisdiction — Grable — If Success of Claim Only Partially Depends on Federal Law, or Does So Only in the Alternative, No JD — If Claims Contradicted by Federal Rules with Force of Law, Then JD But Also Preemption Defense

Manning v. Merrill Lynch Pierce Fenner & Smith, Inc., 2014 U.S. App. LEXIS 21362 (3d Cir. Nov. 10, 2014):

After the District Court denied Plaintiffs' motion to remand this case to New Jersey state court, we granted their petition for an interlocutory appeal. The issue before us is whether there is federal-question jurisdiction over Plaintiffs' state-law claims, which allege that defendants manipulated the price of a stock via abusive "naked" short sales. Short sales are subject to detailed federal regulation under Regulation SHO. New Jersey does not have an analogous provision. However, the question of whether the naked short selling at issue in this case violates New Jersey law (including the state's general securities fraud provisions) need not be answered by reference to Regulation SHO. Because the success of Plaintiffs' state-law causes of action does not "necessarily" depend upon the contents of federal law, this case does not "arise under" the laws of the United States. The presence of an exclusive jurisdiction [*3]  provision governing Regulation SHO does not change the analysis, as such provisions cannot independently generate jurisdiction.
We hold that there is no federal-question jurisdiction over this suit. Accordingly, we will reverse the order denying remand, and direct the District Court to remand this case to the Superior Court of New Jersey.
Plaintiffs are shareholders in Escala Group, Inc. ("Escala"). Named Defendants are financial institutions that engage in equity trading. Plaintiffs filed this lawsuit in the Superior Court of New Jersey alleging that Defendants participated in "naked" short selling of Escala stock, which "increased the pool of tradable shares by electronically manufacturing fictitious and unauthorized phantom shares." (Am. Compl. ¶ 4.) Plaintiffs also refer to these shares as "counterfeit." (Am. Compl. ¶ 37.) Plaintiffs claim that this alleged increase in Escala shares diluted their voting rights and caused their shares to decline in value. The Amended Complaint pleads ten causes of action, with all claims asserted under New Jersey law. These causes of action address: (i) claims under the New Jersey Racketeer Influenced and Corrupt Organizations ("RICO") Act based [*4]  on predicate acts of New Jersey securities fraud and theft; and (ii) common law claims for unjust enrichment, interference with economic advantage and contractual relations, breach of contract, breach of the covenant of good faith and fair dealing, and negligence.
A normal (i.e., non-naked) short sale is usually accomplished in six steps: (1) "[t]he short seller identifies securities she believes will drop in market price;" (2) arranges to "borrow[] these securities from a broker;" (3) "sells the borrowed securities on the open market;" (4) waits some period of time hoping the securities decline in value; (5) "purchases replacement securities on the open market;" and (6) "returns them to the broker--thereby closing the short seller's position." Elec. Trading Grp., LLC v. Banc of Am. Sec. LLC, 588 F.3d 128, 132 (2d Cir. 2009). "The short seller's profit (if any) is the difference between the market price at which she sold the borrowed securities and the market price at which she purchased the replacement securities, less [transaction costs]." Id. Usually a buyer takes delivery of the borrowed securities within three days following the purchase. Amendments to Regulation SHO, SEC Release No. 34-58773, 73 Fed Reg. 61706, 61707 n.8 (Oct. 14, 2008).
However, "[i]n a 'naked' short sale . . . the short seller does not borrow securities in time to make delivery to the buyer within [*5]  the standard three-day settlement period. As a result, the seller fails to deliver securities to the buyer when delivery is due (known as a 'fail' or 'fail to deliver'). Sellers sometimes intentionally fail to deliver securities as part of a scheme to manipulate the price of a security, or possibly to avoid borrowing costs associated with short sales, especially when the costs of borrowing stock are high." Id. at 707-08. Naked short selling is not per se illegal under federal law. However, some naked short selling schemes may run afoul of federal antifraud laws, as well as Regulation SHO. 'Naked' Short Selling Antifraud Rule, SEC Release No. 34-58774, 73 Fed. Reg. 61666, 61667 (Oct. 14, 2008).
Regulation SHO, 17 C.F.R. § 242.200 et seq., was adopted in 2004 by the Securities and Exchange Commission ("SEC" or "Commission"), pursuant to its authority under the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78a et seq. See Short Sales, SEC Release No. 34-50103, 69 Fed. Reg. 48008 (July 28, 2004). Among other restrictions, Regulation SHO imposes "locate" and "close out" requirements on broker-dealers in an attempt to minimize fails to deliver. Under the locate requirement, before executing a short sale order, a broker-dealer must have "reasonable grounds" to believe that the security can be borrowed and delivered within three days. 17 C.F.R. § 242.203(b)(1). If a fail to deliver has occurred and persists for thirteen days, under the "close [*6]  out" requirement broker-dealers may be required to purchase and deliver securities "of like kind and quantity." 17 C.F.R. § 242.203(b)(3); Elec. Trading Grp., 588 F.3d at 135-36.
Although Plaintiffs' causes of action are all brought under state law, the Amended Complaint repeatedly mentions the requirements of Regulation SHO, its background, and enforcement actions taken against some Defendants regarding Regulation SHO. It also cites data maintained to assist broker-dealers in complying with Regulation SHO's close out requirement, and at times couches its allegations in language that appears borrowed from Regulation SHO. Further, plaintiffs plead that "Defendants violated the trading rules and regulations requiring that they actually deliver shares . . . to settle short sale transactions." (Am. Compl. ¶ 33.) There is no question that Plaintiffs assert in their Amended Complaint, both expressly and by implication, that Defendants repeatedly violated federal law. Moreover, there is no New Jersey analogue to Regulation SHO.
Defendants removed the suit from the Superior Court of New Jersey to the United States District Court for the District of New Jersey, premised on the existence of federal-question jurisdiction. Plaintiffs sought remand. On December [*7]  31, 2012, the Magistrate Judge issued a Report and Recommendation suggesting that Plaintiffs' motion to remand be granted: "because [Plaintiffs] may succeed on their New Jersey RICO claims . . . and state common law claims . . . without establishing liability under federal law, the Amended Complaint, on its face, does not raise necessarily a substantial issue of federal law." Manning v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 12-4466, 2012 WL 7783142, at *4 (D.N.J. Dec. 31, 2012). The District Court disagreed in a March 20, 2013 opinion: "the case at bar is premised upon and its resolution depends on the alleged violation of a regulation promulgated under the [Exchange] Act." Manning v. Merrill Lynch, Pierce, Fenner & Smith, Inc., No. 12-4466, 2013 WL 1164838, at *4 (D.N.J. Mar. 20, 2013).
Noting "substantial ground for difference [of opinion] here, as evinced by the different outcome reached by this Court and [the] Magistrate Judge . . . in this case," on May 23, 2013, the District Court certified an interlocutory appeal to this Court, pursuant to 28 U.S.C. § 1292(b), to answer "the question of whether remand is appropriate in this case." Manning v. Merrill Lynch, Pierce, Fenner & Smith, Inc., No. 12-4466, 2013 WL 2285955, at *2 (D.N.J. May 23, 2013). On August 28, 2013, we granted Plaintiffs' petition to appeal.
The sole issue on appeal is whether there is federal-question jurisdiction over Plaintiffs' claims. "The removing party . . . carries a heavy burden of showing that at all stages of the litigation the case is properly before the federal court. Removal statutes are to be strictly construed, with all doubts to be resolved in favor of remand." Brown v. Jevic, 575 F.3d 322, 326 (3d Cir. 2009) (internal citations omitted). Defendants point to two principal statutory provisions they believe confer jurisdiction here: 28 U.S.C. § 1331 and 15 U.S.C. § 78aa ("§ 27" of the Exchange Act).1 Section 1331, the "general federal-question statute," Michigan v. Bay Mills Indian Cmty., 134 S. Ct. 2024, 2030 n.2 (2014), gives district courts original jurisdiction over "all civil actions arising under the Constitution, laws, or treaties of the United States." Section 27 gives district courts "exclusive jurisdiction . . . of all suits in equity and actions at law brought to enforce any liability or duty created by [the Exchange Act] or the rules and regulations thereunder."
1   28 U.S.C. § 1441(a) authorizes removal of "any civil action" over which district courts "have original jurisdiction."
Section 1331 "is invoked by and large by plaintiffs pleading a cause of action created by federal law." [*9]  Grable & Sons Metal Prods., Inc. v. Darue Eng'g & Mfg., 545 U.S. 308, 312 (2005); see also Gunn v. Minton, 133 S. Ct. 1059, 1064 (2013) ("Most directly, a case arises under federal law when federal law creates the cause of action asserted.") (citing Am. Well Works Co. v. Layne & Bowler Co., 241 U.S. 257, 260 (1916)). However, causes of action under state law may nonetheless "arise under" federal law for purposes of § 1331 if the four-pronged Grable test is met. "[F]ederal jurisdiction over a state law claim will lie if a federal issue is: (1) necessarily raised, (2) actually disputed, (3) substantial, and (4) capable of resolution in federal court without disrupting the federal-state balance approved by Congress." Gunn, 133 S. Ct. at 1065 (applying Grable). Only a "slim category" of cases satisfy the Grable test. Empire Healthchoice Assurance, Inc. v. McVeigh, 547 U.S. 677, 701 (2006). Because we conclude that no federal issue has been necessarily raised here, we need not decide whether the other three Grable requirements are met.
For a federal issue to be necessarily raised, "vindication of a right under state law [must] necessarily turn[] on some construction of federal law." Franchise Tax Bd. of State of Cal. v. Constr. Laborers Vacation Trust for S. Cal., 463 U.S. 1, 9 (1983). Grable presented one of the rare instances where a federal issue was necessarily raised. Grable sued under state law to quiet title. Five years prior to the suit, the Internal Revenue Service ("IRS") seized Grable's land to satisfy a tax deficiency. The IRS then sold that land to the defendant. Grable argued [*10]  that the IRS did so without giving sufficient notice as required by federal law. Because "whether Grable was given notice within the meaning of the federal statute is . . . an essential element of its quiet title claim," the Supreme Court held that the issue of what notice was required under federal law was necessarily raised. Grable, 545 U.S. at 315 (emphasis added).
The "classic example," id. at 312, of this type of arising under jurisdiction similarly required a determination of federal law as an essential element of the plaintiff's state law claim. In Smith v. Kansas City Title & Trust Co., 255 U.S. 180 (1921), plaintiff sued under a state law which forbade the defendant from investing in illegal securities. The alleged source of illegality was that the federal bonds purchased by the defendant were unconstitutional (on the theory that Congress did not have the power to issue them). Because the "decision depend[ed] upon the determination of [the constitutional] issue," "which [was] directly drawn in question," federal jurisdiction was proper. Id. at 245-46.
By contrast, Regulation SHO is not an element of any of Plaintiffs' claims. The claims, therefore, could be decided without reference to federal law. Plaintiffs alleged a market manipulation scheme and sued exclusively under New Jersey [*11]  law, including its common law. The District Court, "noting that Plaintiffs do not point to a New Jersey law or regulation which similarly prohibits the type of alleged conduct at issue here," found that the claims were necessarily predicated on the violation of Regulation SHO. Manning, 2013 WL 1164838, at *5. We conclude it was improper for the District Court to foreclose the possibility that particular state causes of action could permit recovery solely under state law. It is true that New Jersey's laws are not as robust as federal laws. But we have previously held that even where "[t]here may be some basis to agree with defendants that [plaintiffs'] view of the state law is incorrect and will be so found[, i]t is . . . for the state court to make the determination as to the applicability of its state law." United Jersey Banks v. Parell, 783 F.2d 360, 367 (3d Cir. 1986).
Indeed, even under federal law, a claim based on "abusive 'naked' short selling as part of a manipulative scheme," can be maintained without a predicate violation of Regulation SHO, because such schemes are "always illegal under the general antifraud provisions of the federal securities laws . . . ." 'Naked' Short Selling Antifraud Rule, 73 Fed. Reg. at 61667. Such manipulative schemes may "drive down a company's stock price" and "undermine the confidence of investors," [*12]  which may, in turn, make investors more "reluctant to commit capital." Id. at 61670. If naked short selling can result in a violation of federal general antifraud provisions independently of Regulation SHO, it is difficult to imagine why naked short selling cannot similarly result in a violation of state general antifraud provisions independently of Regulation SHO. Moreover, the Supreme Court of New Jersey, exercising its common-law authority over New Jersey's general securities fraud provisions, has not shied away from deviating from federal law. See Kaufman v. i-Stat Corp., 165 N.J. 94, 97 (2000) ("Even though the theory of fraud on the market has a place in the securities law of this nation, it is a stranger to New Jersey's securities laws. It is also not consistent with the current requirements for a common-law action for fraud in New Jersey.").
As we read the Amended Complaint, no causes of action are predicated at all on a violation of Regulation SHO. Cf. Lippitt v. Raymond James Fin. Servs., Inc., 340 F.3d 1033, 1037 (9th Cir. 2003), as amended (Sept. 22, 2003) (no jurisdiction even where the complaint "unnecessarily describes the alleged conduct of the defendants in terms that track almost verbatim the misdeeds proscribed by [federal law]"). For example, Plaintiffs do not plead a violation of Regulation [*13]  SHO as a predicate violation for purposes of New Jersey RICO. Nor, for the reasons above, do we think Plaintiffs' causes of action necessarily need to be predicated on a violation of Regulation SHO for Plaintiffs to have a chance at recovering under state law.
But even if Plaintiffs' claims were partially predicated on federal law, federal law would still not be necessarily raised. See Christianson v. Colt Indus. Operating Corp., 486 U.S. 800, 810 (1988) ("[A] claim supported by alternative theories in the complaint may not form the basis for [federal] jurisdiction unless [federal] law is essential to each.").2 Where "[p]laintiffs' state [law] RICO claims allege both federal and state predicate acts," no federal question is necessarily raised because a Plaintiff could "prevail upon their New Jersey RICO claims or any of their other state-law claims without any need to prove or establish a violation of federal law." Fairfax Fin. Holdings Ltd. v. S.A.C. Capital Mgmt., LLC, No. 06-4197, 2007 WL 1456204, at *2-3 (D.N.J. May 15, 2007) (applying Christianson to RICO claims premised on manipulative short selling).
2   Although Christianson concerned 28 U.S.C. § 1338 (dealing with actions "arising under" the patent laws) rather than § 1331, the Supreme Court noted the "identical language" in the two provisions and applied the "same test" to both. 486 U.S. at 808. See also Gunn, 133 S. Ct. at 1064-65 (citing Christianson and applying the Grable § 1331 analysis [*14]  to § 1338).
Defendants also assert jurisdiction under § 1331 on the basis of a Frequently Asked Questions ("FAQ") page on the SEC's website. The website is clear from the outset that the FAQ responses are "not rules, regulations, or statements of the [SEC]," nor has the Commission approved them.3 This website, which we are told refutes Plaintiffs' theory of damages, says that naked short selling does not create "counterfeit shares"--a term Plaintiffs employ liberally in the Amended Complaint. But the phrase "counterfeit shares" does not appear a single time anywhere in the United States Code or the Code of Federal Regulations. Defendants simply cannot carry their burden of establishing jurisdiction based on a "disputed issue of federal . . . law," Grable, 545 U.S. at 310, without identifying a particular source of federal law for the judiciary to interpret.
3   Division of Market Regulation: Responses to Frequently Asked Questions Concerning Regulation SHO, (last visited October 24, 2014).
Even if Plaintiffs' theories are factually contradicted by actual rules with the force of law, as the Eighth Circuit thought similar theories were in Pet Quarters, Inc. v. Depository Trust & Clearing Corp., 559 F.3d 772, 781 (8th Cir. 2009) (referencing National Securities Clearance Corporation rules), Defendants would at best [*15]  be entitled to a preemption defense. "Federal pre-emption is ordinarily a federal defense to the plaintiff's suit. As a defense, it does not appear on the face of a well-pleaded complaint, and, therefore, does not authorize removal to federal court." Metro. Life Ins. Co. v. Taylor, 481 U.S. 58, 63, (1987).4
4   The Eighth Circuit in Pet Quarters held that state law claims against SEC-registered clearing agencies for maintaining a program under rules approved by the SEC (which allowed some naked short selling to occur) were all conflict preempted. Although ostensibly recognizing the rule that preemption does not usually give rise to federal-question jurisdiction, the Eighth Circuit held that the Grable test was satisfied as the complaint "presents a substantial federal question because it directly implicates actions taken by the Commission . . . ." 559 F.3d at 779. Although Defendants argue that the identity of the defendant is not relevant to the Grable inquiry, were we to expand the Eighth Circuit's holding in Pet Quarters to all private defendants anytime a plaintiff's claim was uncomfortably juxtaposed with federal regulations, preemption-like arguments would always create federal-question jurisdiction.
Defendants do not purport to cite a single case regarding [*16]  § 1331 (other than Grable and Gunn) in support of their contention that a question of federal law is necessarily raised here. Nonetheless, defendants do cite D'Alessio v. New York Stock Exchange, Inc., 258 F.3d 93, 101-102 (2d Cir. 2001),5 which held that there was jurisdiction under § 1331 where a court was "require[d] . . . to construe federal securities laws," because the plaintiff alleged that the New York Stock Exchange "failed to perform its statutory duty, created under federal law, to enforce its members' compliance with those laws." The instant case is distinguishable as Plaintiffs' claims could rise or fall entirely based on the construction of state law.
5   Defendants contend D'Alessio supports jurisdiction under § 27. But it was plainly decided under § 1331, id. at 101, and § 27 was only mentioned in the context of what is now prong three of Grable (substantiality) after the necessarily raised issue was resolved. 258 F.3d at 104.
We conclude that § 1331 does not provide a basis to exercise jurisdiction over Plaintiffs' claims.


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