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Section 27 of the Securities Exchange Act confers federal district courts with exclusive jurisdiction over all suits “brought to enforce any liability or duty created by [the Exchange Act] or the rules and regulations thereunder.” On May 16, 2016, the Supreme Court held “the jurisdictional test established by [Section 27] is the same as the one used to decide if a cases ‘arises under’ a federal law” pursuant to 28 U.S.C. § 1331, the general federal question statute.[1] Merrill Lynch, Pierce, Fenner & Smith v. Manning, 2016 WL 2842450 (2016) (Kagan, J.) (Merrill Lynch II).

Background

At issue before the Supreme Court was a suit brought by several former shareholders of Escala Group alleging Merrill Lynch and a number of other financial institutions had devalued Escala stock through “naked” short sales. In a standard short sale, “a person 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.” The short seller profits if the stock price declines between the sale and the repurchase. In a “naked” short sale, on the other hand, the short seller does not actually borrow or otherwise obtain the stock, and thus “never delivers the promised shares to the buyer.” The SEC “regulates such short sales at the federal level” through Regulation SHO, which “prohibits short sellers from intentionally failing to deliver securities.”

The Escala plaintiffs brought suit in New Jersey state court claiming defendants’ allegedly naked short sales violated New Jersey law. While the complaint “referred explicitly” to defendants’ alleged violation of Regulation SHO, plaintiffs did not assert any claims under the federal securities laws or the SEC’s rules. Merrill Lynch removed the case to federal court, asserting federal jurisdiction under both the general federal question statute (Section 1331) and Section 27 of the Exchange Act. The district court denied plaintiffs’ motion to remand, but the Third Circuit reversed.

The Third Circuit held Section 1331 “did not confer jurisdiction of the suit, because all [plaintiffs’] claims were ‘brought under state law’ and none ‘necessarily raised’ a federal issue.” Id. (quoting Manning v. Merrill Lynch, Pierce, Fenner & Smith, 772 F.3d 158 (3d Cir. 2014)). The Third Circuit further held Section 27 “covers only those cases involving the Exchange Act that would satisfy the ‘arising under’ test of the federal question statute.” Finding no federal jurisdiction under either Section 27 or Section 1331, the Third Circuit remanded plaintiffs’ case to New Jersey state court.

Merrill Lynch petitioned the Supreme Court for certiorari. On June 30, 2015, the Court granted certiorari to address the question of whether Section 27 “provides federal jurisdiction over state-law claims seeking to establish liability based on violations of the [Exchange Act] or its regulations or seeking to enforce duties created by the [Exchange Act] or its regulations.” Petition for Certiorari, Merrill Lynch, Pierce, Fenner & Smith v. Manning, No. 14-1132 (U.S. March 17, 2015).

Supreme Court Holds Section 27 Provides for Exclusive Federal Jurisdiction of Suits “Arising Under” the Exchange Act Within the Meaning of the General Federal Question Statute

Agreeing with the Third Circuit’s analysis, the Supreme Court “read § 27 as conferring exclusive federal jurisdiction of the same suits as ‘aris[e] under’ the Exchange Act pursuant to the general federal question statute.” Merrill Lynch II, 2016 WL 2842450.

Section 1331’s “arising under” test provides for exclusive federal jurisdiction when (1) “federal law creates the cause of action asserted[,]” or (2) a state-law claim “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.” Applying the second prong of this “arising under” test to Section 27, the Supreme Court stated that federal courts would have exclusive jurisdiction over “a state law cause of action . . . ‘brought to enforce’ a duty created by the Exchange Act because the claim’s very success depends on giving effect to a federal requirement.” The Court further stated that a state-law action “could also fall within § 27’s compass” if it “necessarily depends on a showing that the defendant breached the Exchange Act.”

The Supreme Court rejected Merrill Lynch’s contention that Section 27 should be read expansively to cover state law actions that explicitly or implicitly reference Exchange Act violations. The Court found Section 27 “confers federal jurisdiction when an action is commenced in order to give effect to an Exchange Act requirement” but “stops short of embracing any complaint that happens to mention a duty established by the Exchange Act.”

Supreme Court Holds Section 1331’s “Arising Under” Test Applies to Section 27 Even Though the Two Provisions Use Different Statutory Language

The Supreme Court acknowledged that the general federal question statute refers to cases “arising under” federal law, while Section 27 addresses cases “brought to enforce” duties or liabilities under the Exchange Act. However, the Court found “the test for § 1331 jurisdiction is not grounded in that provision’s particular phrasing.” Because the “arising under” test “does not turn on § 1331’s text,” the Court determined “there is nothing remarkable” in applying the test to “a differently worded statutory provision.”

The Court rejected Merrill Lynch’s contention that Congress’s use of the phrase “brought to enforce” in Section 27 evinced an intent to depart from Section 1331’s “arising under” test. The Court explained that “caselaw construing § 1331 was for many decades — including when the Exchange Act passed — highly ‘unruly.’” “Against that muddled backdrop,” the Court found it “impossible to infer that Congress, in enacting § 27, wished to depart from what we now understand as the ‘arising under’ standard.”

Supreme Court Finds Applying the “Arising Under” Jurisdictional Test to Section 27 Gives Appropriate Due Deference to State Courts

In addition to the administrative simplicity of applying Section 1331’s “arising under” test to Section 27, the Court found this approach “gives due deference to the important role of state courts in our federal system.” The Court explained that “when a statute mandates, rather than permits, federal jurisdiction — thus depriving state courts of all ability to adjudicate certain claims—[the Court’s] reluctance to endorse ‘broad reading[s]’ . . . grows stronger.”

The Court observed that “Congress likely contemplated that some complaints intermingling state and federal questions would be brought in state court[.]” The Court pointed out that “Congress specifically affirmed the capacity of [state] courts to hear state-law securities actions, which predictably raise issues coinciding, overlapping, or intersecting with those under the [Exchange Act] itself.”

In cases like the one before it, the Court found it “hardly surprising” that plaintiffs “alleging short sales in violation of state securities law . . . might say the defendant previously breached a federal prohibition of similar conduct.” The Court determined that “it is less troubling for a state court to consider such an issue than to lose all ability to adjudicate a suit raising only state-law causes of action.”

The Court held the case before it did not “arise under” the Exchange Act within the meaning of Section 27, and affirmed the Third Circuit’s decision remanding the action to New Jersey state court.

Justices Thomas and Sotomayor, Concurring, Express Their View That the “Arising Under” Test Does Not Apply to Section 27

In a concurring opinion joined by Justice Sotomayor, Justice Thomas expressed his view that Section 27 “does not use the phrase ‘arising under’ or provide a sound basis for adopting the arising-under standard.” Justice Thomas underscored that Section 27 instead provides federal jurisdiction where a suit is “‘brought to enforce’ Exchange Act requirements.” He stated that Section 27 “establishes a straightforward test: If a complaint alleges a claim that necessarily depends on a breach of a requirement created by the [Exchange Act], § 27 confers exclusive federal jurisdiction over that suit.”

Justice Thomas concurred in the judgment remanding the action to state court because the complaint at issue did “not allege such claims.”