(CN) — Merrill Lynch and other brokerage firms must face a state court case that says illegal naked short sales cost investors more than $800 million, the U.S. Supreme Court ruled Monday.
The shareholders brought their case four years ago in New Jersey over the Fortune 500 memorabilia company Spectrum Group International, then known as Escala Group.
One of the investors, Greg Manning, said "naked short selling" sent his more than 2 million Escala shares into a nosedive.
In typical short sales, investors speculate that the price of a stock will decline and purchase securities that they do not currently own in order to profit from the fall. Securities laws and regulations mandate that a short seller borrow the stock it sold and deliver it within four days of sale.
A so-called "naked" short sale is illegal because it disregards such regulations.
"If the short seller never borrows or otherwise obtains the stock it sold short, the short seller cannot convey or deliver authorized or legitimate stock to the purchase," the investors' original complaint states.
In addition to Merrill Lynch, Manning's lawsuit took aim at Pierce, Fenner & Smith, UBS Securities and E-Trade Capital Markets. It said the brokerages' use of this practice — in May and December 2006 — diluted and artificially depressed the shares' value so that the defendants could repurchase them for cheap, return them to the lender, and profit on the difference.
Since its filing, the case has languished over jurisdictional issues. Merrill Lynch and the other companies removed the case to federal court on the basis of the federal securities laws in play.
U.S. District Judge Jose Linares agreed with this reasoning, but the Third Circuit overturned that decision in 2014, remanding the case to Morris County Superior Court.
"As we read the amended complaint, no causes of action are predicated at all on a violation of Regulation SHO," Judge D. Brooks Smith wrote for a three-judge panel, referring to the Securities and Exchange Commission's rule on short sales (emphasis in original).
The U.S. Supreme Court affirmed 8-0 on Monday, saying Merrill Lynch's alternative standard "would spring out of nothing to govern suits involving not only the Exchange Act but up to nine other discrete spheres of federal law."
"Adopting such an untested approach ... would undermine consistency and predictability in litigation," the decision by Justice Elena Kagan states. "That result disserves courts and parties alike.
"Making matters worse, Merrill Lynch's rule is simple for plaintiffs to avoid — or else, excruciating for courts to police," the ruling continues. "Under that rule, a plaintiff electing to bring state-law claims in state court will purge his complaint of any references to federal securities law, so as to escape removal. Such omissions, after all, will do nothing to change the way the plaintiff can present his case at trial; they will merely make the complaint less informative."
Kagan emphasized that "jurisdictional tests are built for more than a single dispute."
"That Merrill Lynch's threatens to become either a useless drafting rule or a tortuous inquiry into artful pleading is one more good reason to reject it," she added.
Justice Sonia Sotomayor joined a opinion concurring in judgment by Justice Clarence Thomas, which says the court should have looked no further than Section 27 of the Securities Exchange Act of 1934,
Attorneys for the investors with Stris & Maher in Los Angeles called the decision "one of extraordinary importance for states and for the investing public."
The firm's attorney Peter Stris, who argued the case, did not immediately return a telephone request for comment explaining the significance of this jurisdictional issue for his clients.
Merrill Lynch's parent, Bank of America, said the underlying lawsuit lacks merit.
"We will defend against the substantive allegations in state court, where we already have filed for dismissal," BofA spokesman Lawrence Grayson said in an email.
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