Securities litigation shifting to state courts

Supreme Court decision gives its blessing to a clever path around obstacles found in federal judiciary

May and June are the traditional months for graduation ceremonies, weddings and United States Supreme Court opinions. For the justices, it’s a rush to clear their desks before taking off on their three-month vacations. And so, every year in late spring, the court issues a spate of opinions, a handful of which affect business. This column and the next will review some of the spring season’s new business law looks.

In the words of the late Chief Justice William Howard Taft, the Supreme Court has “absolute and arbitrary discretion” to pick and choose which cases to hear. Every year, some 7,000 to 8,000 cases are presented to the justices, according to the court’s own website. Last year, the court decided a grand total of 74 of them and even that number was swollen by summary reversals, terse orders ranging in length from a few paragraphs to a few pages. In short, the Supreme Court’s principal business isn’t deciding cases. Mainly, it decides not to hear cases.

The court is more likely to hear a case if a party can demonstrate the existence of a “circuit split.” The nation is governed by 12 regional circuit courts of appeals. When judges of different circuits are presented with identical issues, but reach inconsistent or opposite results, a circuit split is formed. Only the Supreme Court has the authority to resolve a circuit split.

Earlier this month, the court resolved one such split in a securities law case known as Merrill Lynch v. Manning. The case involves the corporation formerly known as Escala Group, which in its glory days described itself in a press release as “a global federation of leading companies in the collectibles market.” For a brief time, its share price made it the “third-largest conglomerate in the collectibles industry, after Christie’s and Sotheby’s,” according to Fox News. Founder Greg Manning owned more than two million shares in the corporation.

Now, anyone who invests in collectibles understands the markets are volatile. And anyone who’s read or seen “The Big Short” knows that securitizing assets can have the effect of exaggerating market volatility.

Escala investors were buying securities whose value ultimately rested on the highly subjective valuation of stamps and coins. That’s two distinct layers of speculation, which sounds risky enough. But the company, which has since changed its name, was also accused of various questionable practices, as a Web search quickly reveals. Its name appears in news stories that also mention “Ponzi” and “Enron.” So it hardly seems a shock to learn its stock lost nearly four-fifths of its value in early 2008.

But Manning insisted the price collapse wasn’t due to the nature of the business or its particular methods. Instead, he claimed it was the fault of Merrill Lynch and other financial firms, which he accused of engaging in “naked short sales.” Naked short sales are a way to depress the price of a security. In simplest terms, a market manipulator can place a bet that a given stock will fall, then use naked short sales to drive down the price. In such a rigged game, honest investors lose their shirts. With some exceptions, naked short sales are forbidden by SEC Regulation SHO. (If you want more detail, the SEC website has a page titled “Key Points About Regulation SHO.”)

Manning sued in New Jersey court, claiming Merrill Lynch violated Regulation SHO. But he very carefully didn’t seek recovery for that alleged violation of federal law. Rather, he claimed that, by violating federal law, Merrill Lynch also violated New Jersey state law and he sought compensation only for the state law violations.

Merrill Lynch responded by “removing” the case to federal court. Removal is the term used for the forced transfer of a case from state to federal court. The case is, literally, removed from state court and relocated in federal court. Removal, which changes nothing about a case except the identity of the court in which it is litigated, is permitted when a lawsuit raises questions of federal law. Merrill Lynch argued that, by alleging a violation of Regulation SHO, Manning raised a question of federal law, even though he didn’t seek recovery for it.

The federal district judge agreed with Merrill Lynch, taking up sides in a circuit split. But the Supreme Court reached the opposite conclusion, sending the case back to state court because Manning so carefully sought recovery only under state law.

Left unstated in the 28 pages of the Supreme Court’s unanimous opinion is the reason why Manning didn’t seek recovery for the alleged violation of Regulation SHO and why Merrill wanted so badly for the case to be heard in federal court. Both sides demonstrated by their actions a shared belief that Manning had a much better chance of prevailing in New Jersey state court. The Supreme Court’s intricate legal discussion didn’t acknowledge the real point of the case, which is that the choice of federal versus state court can make all the difference to the outcome of a case.

In federal court, plaintiffs in securities actions face difficult procedural obstacles, put in place in recent years by Congress and by the Supreme Court itself. Those obstacles can be defended as pro-business as long as “business” is defined as the financial industry.

Escala Group isn’t a very sympathetic representative of Main Street business but, if its allegations are even partially true, they show how vulnerable public companies are to market manipulation. With this new decision, the Supreme Court has given its blessing to a clever path around the obstacles, potentially ushering in a new era in securities litigation, one in which state courts become the main theater of action.