MANNING et al v. MERRILL LYNCH, PIERCE, FENNER & SMITH, INC. et al

Filing 48

OPINION. Signed by Judge Jose L. Linares on 3/18/13. (DD, )

NOT FOR PUBLICATION

UNITED STATES DISTRICT COURT
DISTRICT OF NEW JERSEY

GREG MANNING, et al.,

Plaintiffs,

Civil Action No.: 12-4466 (JLL)

OPINION

V.

MERRILL LYNCH, PIERCE, FENNER &
SMITH, INC. et a!.,

Defendants.

This matter comes before the Court by way of
the December 31, 2012 Report and
Recommendation by the Magistrate Judge Mich
ael Hammer and the objections submitted
thereto by Defendants Merrill Lynch, Pierce, Fenn
er & Smith, Inc., Knight Capital
Americas, L.P., UBS Securities, L.L.C., E*TRADE
Capital Marks, L.L.C., National
Financial Services, L.L.C. (collectively “Def
endants” or “Merrill Lynch”). Upon
consideration of the objections submitted
by Defendants, the Court ordered Plaintiffs to
submit a response, which they did on March
4, 2013 (CM/ECF No. 44). On March 8,
2013, Defendants filed a letter in response to
Plaintiffs’ submission. (CMIECF No. 45))
For the reasons set forth below, upon
novo consideration of the issues objected
to by

‘Defendants filed the March 8, 2013, letter with
out seeking permission from the Court.
However, the letter addresses a case decided
by the Supreme Court after the filing of
Defendants’ Objection on which Plaintiffs rely.
Accordingly, the Court will consider the
letter, as Plaintiffs did not object to same.

Defendants, the Court DENIES Plaintiffs’ motion to remand this matter to the Superior
Court of New Jersey.
Plaintiffs allege that Defendants engaged in illegal and manipulative “naked short
selling” of Escala Group, Inc. (“Escala Group”), of which they own shares. “Short
selling’ is the practice of borrowing shares of stock, selling them and seeking to
repurchase those shares at a lower price, returning the lower-priced shares to the lender
and keeping the difference as profit.” Fairfax Financial Holdings, Ltd. v. S .A.C. Capital
Management, LLC, Civ. No. 06-4197, 2007 WL 1456204, at *1 (D.NJ. May 15, 2007)
(Cavanaugh, J.). The parties do not dispute that “short selling” is a legal practice. As
explained by Judge Hammer, however, “naked short-selling’ occurs when traders sell
shares they do not own or borrow, or ever intend to own, and never deliver the
‘borrowed’ securities that they sell.” (Report and Recommendation, 2-3) (citing
Avenius v. Bane of Am. Sec. LLC, Civ. No. 06-4458, 2006 WL 4008711 at * 1 (N.D. Cal.
Dec. 30, 2006); Capece v. DTCC, 2005 U.S. Dist. LEXIS 42039, at *1 (S.D. Fla. Oct. 11,
2005)). As noted above, that is the practice with which Plaintiffs premise their Amend
ed
Complaint.
In other words, Plaintiffs allege that Defendants sold shares they did not own or
borrow, or ever intend to own, which created and circulated unauthorized or counte
rfeit
shares of Escala Group, diluting and artificially depressing their value. During May
and
December of 2006, Defendants allegedly entered millions of proprietary and custom
er
short sale transactions without having reasonable grounds to believe that the securit
ies
could be borrowed and be available for delivery. (Compi.

2

¶ 4).

Plaintiffs commenced this action with the filing of a Complaint on May 8, 2012,
in the Superior Court of New Jersey, Law Division, Morris County. (CM!ECF No. 1).
On June 7, 2012, Plaintiffs filed an Amended Complaint in the Superior Court of New
Jersey. (CMJECF No. 1). Defendants removed the action to this Court on July 17, 2012.
At that time, as now, Defendants contend that removal is proper on two separate grounds:
(1) the Court is vested with exclusive jurisdiction under Section 27 of the Securities
Exchange Act of 1934, 15 U.S.C. § 78aa (“Exchange Act” or the “Act”); and (2) the
Court is vested with original jurisdiction because Plaintiffs’ claims raise, and arise under,
federal law. Plaintiffs filed a motion to remand and for an award of attorneys’ fees on
August 16, 2012. (CMJECFNo. 11).
LEGAL STANDARD
When the magistrate judge addresses motions that are considered “dispositive,”
such as to grant or deny a motion to dismiss, a magistrate judge will submit a Report and
Recommendation to the district court. 28 U.S.C. § 636(b)(1)(A); Fed. R. Civ. P. 72; L.
Civ. R. 72.1(a)(2). The district court may then “accept, reject or modify, in whole or in
part, the findings or recommendations made by the magistrate [magistrate judge]. The
judge may also receive further evidence or recommit the matter to the magistrate with
instructions.”

28 U.S.C. § 636(b)(1)(C); see also L. Civ. R. 72.1(c)(2).

Unlike an

Opinion and Order issued by a magistrate judge, a Report and Recommendation does
not
have force of law unless and until the district court enters an order accepting or rejectin
g
it. United Steelworkers of Am. v. N. J. Zinc Co., Inc., 828 F.2d 1001, 1005 (3d Cir.
1987).

3

The standard of review of a magistrate judge’s determination depends upon
whether the motion is dispositive or non-dispositive. With respect to dispositive motion
s,
the district court must make a de novo determination of those portions of the magist
rate
judge’s Report to which a litigant has filed an objection. 28 U.S.C.

R. civ.

.

§ 636(b)(1)(C); Fed.

72(b); L. Civ. R. 72.1(c)(2); see also State Farm Indem. v. Fomaro, 227 F.

Supp. 2d 229, 231 (D.N.J. 2002); Zinberg v. Washington Bancorp, Inc., 138 F.R.D. 397,
401 (D.N.i. 1990) (concluding that the court makes a

novo review of the parts of the

report to which the parties object).
As previously noted, Defendants object to the Report and Recommendation and
argue that it misconstrues the following: (1) the scope of exclusive jurisdiction under
Section 27 of the Exchange Act, 15 U.S.C. § 78aa; and (2) Defendants’ argum
ent
regarding federal question jurisdiction and the applicability of the Supreme Court’
s
decision in Grable & Sons Metal Prods., Inc. v. Dame Eng’g & Mfg., 545 U.S. 308,
31314 (2005). Accordingly, the Court will determine

novo whether remand is appropriate

in light of Defendants’ objections. See In re U.S. Healthcare, 159 F.3d 142, 146
(3d Cir.
1998).
The party asserting federal jurisdiction by way of removal bears the burden
of
establishing that federal subject matter jurisdiction exists. Samuel-Bassett v. KIA
Motors
Am., Inc., 357 F.3d 392, 396 (3d Cir. 2004). A defendant may remove to federal
court an
action brought in state court if the plaintiff could have filed the complaint within
the
original jurisdiction of the federal court. 28 U.S.C.
§ 1441. Courts should construe
Section 1441 strictly and resolve all doubts in favor of remand. Samuel-Basse
tt, 357
F.3d at 396. The existence of federal jurisdiction must be decided on
the face of the

4

complaint.

Merrell Dow Pharms. v. Thompson, 478 U.S. 804, 808 (1986) (“[T}he

question whether a claim ‘arises under’ federal law must be determined by referen
ce to
the ‘well pleaded complaint’) (quoting Franchise Tax Bd. of State of Cal. v. Contru
.
Laborers Vacation Trust for S. Cal., 463 U.S. 1, 9-10 (1983)).

DISCUSSION
Plaintiffs’ Amended Complaint alleges that “Defendants substantially injured
Plaintiffs while at the same time reaping enormous profits by knowingly and
intentionally, creating, loaning and selling unauthorized, fictitious and counterfeit
shares
of Escala stock, through various unlawful schemes and devices and by engaging in
the
unlawful practice of naked short sales.” (Compi. ¶ 1). Specifically, the Amended
Complaint asserts the following causes of action under state law: (1) violation
of New
Jersey RICO, N.J.S.A. 2C:41-l et. seq. predicated on violations of the New Jersey
Uniform Securities Law, N.J.S.A. 49:3-49 et seq., theft by taking in contravention
of
N.J.S.A. 2C:20-2 et seq., and theft by deception counter to N.J.S.A. 2C:20-4; (2)
unjust
enrichment; (3) unlawful interference with prospective economic advantage;
(4) tortious
interference with contractual relations; (5) unlawful interference with contractual
relations; (6) third party beneficiary claims; (7) breach of covenant of good
faith and fair
;
2
dealing and (8) punitive and exemplary damages.
Notably, Plaintiffs do not dispute that the alleged unlawful conduct is predica
ted
on a violation of Regulation SHO, 17 C.F.R.

§ 242.204, promulgated by the Securities

and Exchange Commission (“SEC”). Indeed, the Amended Complaint
also provides:
2

For the sake of completeness, the Amended Complaint designates both the breach
of the covenant of good
faith and fair dealing, and the third party beneficiary cause of action as “Count
Six.”

5

[t]here are certain Defendants who have been fined millions of dollars by
the [SEC] and the Financial Industry Regulatory Authority (“FINRA”) for
their intentional and persistent violation of the rules and regulations
governing their unlawful short selling activities. These fines and
sanctions, however, have not deterred these Defendants, which view them
merely as “pocket change” and the “cost of doing business.”
(Compi.

¶ 6).

“Federal courts are courts of limited jurisdiction,’ possessing ‘only that power
authorized by Constitution and statute.” Gunn v. Minton, 133 S.Ct. 1059, 1064 (2013)
(quoting Kokkonen v. Guardian Life Ins. Co. of America, 511 U.S. 375, 377 (1994)).
Generally, federal question jurisdiction may be invoked in two instances: (1) where
plaintiffs plead a cause of action created by federal law; and (2) certain state-law claims
that implicate significant federal issues. Grable, 545 U.S. at 312. Recently, the Suprem
e
Court reiterated that the latter is “a ‘special and small category’ of cases.” Gunn, 133
S.Ct. at 1064 (quoting Empire Healthchoice Assurance, Inc. v. McVeigh, 547 U.S. 677,
699 (2006)).
As noted above, Defendants contend that removal is proper on two separate
grounds: (1) the Court is vested with exclusive jurisdiction under Section 27 of
the
Exchange Act ; and (2) the Court is vested with original jurisdiction because Plainti
ffs’
claims raise, and arise under, federal law. The Court will address each.

1. The scope of exclusive jurisdiction under Section 27 of the Exchange
Act
As an initial matter, no party points to controlling authority on the issue of
whether Section 27 of the Exchange Act provides exclusive federal jurisdi
ction under the
specific circumstances raised in this case, namely, where state claims are
predicated on a
violation of the Exchange Act. Defendants contend that “Plaintiffs’ allegations
that

6

Defendant violated Regulation SHO’ s locate requirement, which, with certain
exceptions,
compels short sellers to have reasonable grounds to believe that a stock
can be borrowed
before selling it short” brings those claims squarely within the purview
of Section 27.
(Defs.’ Opp’n. 3).
Plaintiffs rely on Fairfax, to argue that the instant matter should be remand
ed. In
that case, the defendants allegedly engaged in the practice of manipulative
short selling,
by conspiring to devastate the business and reputation of the plaintiff. Specif
ically,
defendants allegedly disseminated corrupt and materially misleading equity
research
regarding plaintiff’s business condition, defamed plaintiff, and harassed
the plaintiffs
agents and employees. 2007 WL 1456204, at

*

1. The plaintiffs in that case filed a

complaint in the Superior Court of New Jersey which asserted claims
pursuant New
Jersey’s RICO and common law. The court remanded the case, holdin
g, in relevant part,
that “Section 27 does not grant.

.

.

exclusive jurisdiction because [p]laintiffs’ action is

not an action brought to enforce the securities laws. Rather, Plaintiffs’
allegations that
Defendants violated provisions of the Exchange Act merely support Plainti
ffs’ state
causes of action.” 2007 WL 1456204, at

*

5. Therefore, the court concluded that Section

28 saved plaintiffs’ New Jersey RICO claims predicated on a violati
on of the Exchange
Act. id.
3
Section 27 provides, in relevant part, as follows:
The district courts of the United States
shall have exclusive
jurisdiction of violations of this chapter or the rules and regulations
thereunder, and of all suits in equity and actions at law brought
to enforce
.

.

.

.

The court reasoned that “Section 28 of the Act preserves state causes
of action: ‘the
rights and remedies provided by this chapter shall be in additio
n to any and all other
rights and remedies that may exist in law or equity.”
(quoting 15 U.S.C. § 78bb)
(alterations omitted).

7

any liability or duty created by this chapter or the rules and regulations
thereunder.
15 U.S.C. § 78aa. “Section 27 of the Exchange Act confers exclusive jurisdiction upon

the federal courts for suits brought to enforce the Act or rules and regulations
promulgated thereunder.” Matsushita Elec. Indus. Co. v. Epstein, 516 U.S. 367, 370
(1996). As the case at bar is premised upon and its resolution depends on the alleged
violation of a regulation promulgated under the Act, this Court has jurisdiction. Saks v.
Dietrick, 663 F.3d 1065, 1068 (9th Cir. 2011); Sparta Surgical Corp. v. NASD, Inc.,
159
F.3d 1209, 1211-12 (9th Cir. 1998); see D’Alessio v. NYSE, Inc., 258 F.3d 93, 101-02
(2d Cir. 2001). In addition, the Fairfax decision is distinguishable here because, unlike
Fairfax, this case is premised upon enforcement of the federal Exchange Act and
corresponding rules and regulations.

2. “Arising Under” Jurisdiction
Defendant argues that there is federal jurisdiction under 28 U.S.C.
§ 1331 and 1337
because Plaintiffs’ causes of action depend upon the resolution of a federal issue, namely
violation of the Exchange Act and federal regulations, and raise the substantial federal
question of whether naked short sales in the National Clearance and Settlement System
(the “National System”) create “counterfeit” shares. Thus, Defendants maintain
that the
Report and Recommendation misconstrues the applicability of the Supreme Court’
s
decision in Grable, 545 U.S. at 3 13-14.
The doctrine of federal “arising under” jurisdiction “captures the commonsense
notion that a federal court ought to be able to hear claims recognized under
state law that
nonetheless turn on substantial questions of federal law, and thus justify resort to
the

8

experience, solicitude, and hope of uniformity that a federal forum offers on federal
issues.” Grable, 545 U.S. at 312. The requisite inquiry to determine whether state law
claims implicate sufficient federal issues is as follows: (1) does a state-law claim
necessarily raise a stated federal issue; (2) is the federal issue actually disputed; (3) is the
federal issue substantial; and (4) would entertaining the issue disturb the congressionally
approved balance of federal and state judicial responsibilities.

at 314. Applying that

test here, Plaintiffs’ claims arise under federal law.
First, the federal issue is necessarily raised by Plaintiffs’ claims. Indeed, those
claims are predicated on Defendants’ alleged naked short sales of Escala stock in
violation of SEC Regulation SHO. To prevail on their various state law claims,
therefore, Plaintiffs must show that the alleged naked short sales were illegal. As
Defendants argue in their Opposition to Plaintiffs’ motion to remand, “[iif, as the SEC
has concluded, naked short selling does not create counterfeit shares, Plaintiffs have no
cognizable injury, and their claims must be dismissed.” (Defs.’ Opp’n. 30-31). It bears
noting that Plaintiffs do not point to a New Jersey law or regulation which similarly
prohibits the type of alleged conduct at issue here.
Second, the federal issue is disputed. Defendants argue that “Plaintiffs’ claims in
this case are impossible to adjudicate without determining whether Plaintiffs are correct
that so-called ‘naked’ short selling creates ‘counterfeit shares.’ This is because Plainti
ffs’
only basis for damages is their claim that the alleged ‘counterfeit shares’ diluted the value
of their ‘legitimate’ Escala shares.” (Def.’s Obj. 8). The viability of Plaintiffs’ claims
turns on that issue and Plaintiffs seek damages incurred as a result of the dilution and
artificially depressed value of their shares.

9

In addition, the federal issue is substantial.

Empire HealthChoice Assurance,

Inc. v. McVeigh, 574 U.S. 677, 700-01 (2006). Resolution of Plaintiffs’ claims depends
on the disputed issue. Determination as to whether the alleged naked short selling creates
phantom shares would also impact subsequent lawsuits. Further, the issue is important to
the federal system as a whole. Recently, in Gunn v. Minton, the Supreme Court
cons idered whether a plaintiff’s legal malpractice claim, which involved the viability of
an experimental-use argument in an underlying patent case, arose under federal patent
law. Expounding on the substantiality component of the Grable inquiry, the Supreme
Court wrote: “it is not enough that the federal issue be significant to the particular parties
in the immediate suit; that will always be true when the state claim ‘necessarily raises’ a
disputed federal issue, as Grable separately requires. The substantiality inquiry under
Grable looks instead to the importance of the issue to the federal system as a whole.” 133
S.Ct. at 1066. The Court in Gunn reasoned that the federal issue was not substantial
because the federal patent question in that case was hypothetical “due to the backwardlooking nature of a legal malpractice claim.” Id.. at 1066-67. Similarly, allowing state
courts to resolve the case would not “undermine the development of a uniform body of
patent law.”

(alterations and quotations omitted).

It is worth noting that the issuance of the Report and Recommendation in this
matter preceded the Gunn and, accordingly, Judge Hammer did not have the benefit of
that decision. In this case, Defendants argue that “the existence of ‘counterfeit shares’
presents a substantial issue of federal law because it requires analysis of the regulations
governing the federally sanctioned system for securities trading. Indeed, if naked
short
selling did create ‘counterfeit shares,’ as Plaintiffs claim

10

—

and the SEC has denied—then

the entire federal system for short selling would be called into question.” (Def.’ s Obj. 9).
Plaintiff, on the other hand, draws a parallel between the current New Jersey RICO
claims and the attorney malpractice claim in Gunn to argue that the violation of
Reguation SHO constitutes a “case within a case.” (Pis.’ Resp. 9). Therefore, they
argue, “Laipplying Gunn to the case at bar, there is an insufficient link in Plaintiff’s state
RICO claims to the substantial federal issues of law. Simply because Defendants claim
that there are important issues to the federal system at stake does not make it true.

.

.

(Pis.’ Resp. 10).
In response, Defendants urge that Plaintiffs’ theory threatens the uniform
administration of the federal securities scheme. “To win relief, Plaintiffs must prove
violations of Regulation SHO and other federal regulations. In the absence of federal
jurisdiction, such claims would be subject to state courts, not uniform federal
adjudication. Plaintiffs must also prevail on their ‘counterfeit share’ theory to show
any
injury under their Complaint.” (Defs.’ Resp. 2). In addition, the theory of relief
throws
into question the entire federal scheme for regulating short selling.

“Specifically, if

Plaintiffs prevail on this point, certain aspects of short selling explicitly permit
ted under
the federal regulations would be subject to state liability, raising clear proble
ms for the
decisions made by federal regulators and the uniformity of the federal regulat
ory
scheme.” Id.
The Court finds the instant case distinguishable from the backward lookin
g
malpractice “case within a case” at issue in Gunn. Rather, as Defendants
argue, other
federal courts have found that the existence of “counterfeit shares” raises
a substantial
federal issue. Pet Ouarters, Inc. v. Depository Trust & Clearing Corp.,
545 F. Supp. 2d

11

845, 848-49 (E.D. Ark. 2008); Capace v. DTCC, Civ. No. 00-5404, 2005 WL 4050118,
at *8 (S.D. Fla. Oct. 11,2005).
Plaintiffs urge that relevant case law demonstrates that “cases removed to federal
court have consistently been remanded where the predicate acts alleged under state
RICO
statutes include violations of the federal securities laws, such as the Exchange Act.”
(Pis.’ Mot. 1,9-11) (citing Fairfax, 2007 WL 1456204, at *5 (D.N.J. May 15,
2007);
Meinders v. Fefco Sec., Inc., 865 F. Supp. 721, 723 (D. Cob. 1994); Horowitz
v. Marlton
Oncology, P.C., 116 F. Supp. 2d551, 554-556(D.N.J. 1999)). In the context of
a
previous motion to remand, this Court has previously interpreted the two Distric
t of New
Jersey cases cited by Plaintiffs and explained that it declines to permit those decisio
ns to
“stand for the broad proposition that no federal interest, however important, can
support
federal jurisdiction if it is brought through the vehicle of state law.” Ortiz v.
University
of Medicine & Dentistry of New Jersey, Civ. No. 08-2669, 2009 WL 21947
82, at *4
(D.N.J. Mar. 18, 2009). In this case, the Court finds that the Amended Compl
aint sets
forth a substantial question of federal law. Accordingly, the third prong
of the Grable test
is satisfied. 545 U.S. at 314.
Finally, entertaining the issue would not disturb the congressionally approv
ed
balance of federal and state judicial responsibilities. The instant matter primar
ily
involves the issue of whether the complained of conduct is consistent
with Defendants’
obligations under the Exchange Act and regulations promulgated thereun
der. See
Friedlander v. Troutman, Sanders, Lockerman & Ashmore, 788 F.2d
1500, 1504 (11th
Cir. 1986) (noting that “[t]he comprehensive scheme of statutes and regulat
ions designed
to police the securities industry is indicative of a strong federal interest.”).
In addition to

12

the fact that the Court determined above that it has exclusive jurisdiction under
Section
27 of the Exchange Act, it is worth reiterating that the decisions of other courts
indicate

that Congress intended federal courts to have exclusive jurisdiction of violati
ons of the
Exchange Act and rules and regulations promulgated thereunder. Saks v. Dietric
k, 663
F.3d 1065, 1068 (9th Cir. 201 1); D’Alessio v. NYSE, Inc., 258 F.3d 93, 101-02
(2d Cir.
2001); Sparta Surgical Corp. v. NASD, Inc., 159 F.3d 1209, 1211-12 (9th
Cir. 1998).
This case does not involve a specific body of law in which New Jersey
has a similar
interest, such as regulating professionals within that jurisdiction.
6 10193, at

*

S Gunn, 2013 WL

10. Indeed, Plaintiffs do not point to a violation of New Jersey’s securities

law. In the case at bar, the essence of the Amended Complaint is that violati
on of
Regulation SHO and other federal regulations gave rise to a number of state
claims.
Thus, this case is distinguishable from Fairfax which involved allegations
of lawful short
selling in conjunction with dissemination of corrupt and materially mislea
ding equity
research regarding the plaintiffs business condition, defamation, and harassm
ent of
plaintiff’s agents and employees. Defendants argue that “so long as
parties like Plaintiffs
choose to assert their ‘counterfeit shares’ theory and other securities argum
ents in
nominal state-law claims such as the ones presented here, federal courts
would never
have the opportunity to rule on them.” (Defs.’ Resp. 3). Accordingly,
the instant matter
would not disturb the balance between state and federal judicial respon
sibilities.

CONCLUSION
Therefore, for the reasons stated above, upon

novo consideration of the

portions of the Report and Recommendation to which there were
objections, the Court

13

finds that there is federal jurisdiction over the instant matter. Accordingly, the Court
DENIES Plaintiffs’ motion to remand.

An appropriate Order accompanies this Opinion.
Dated

H
Linares
States District Judge

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