Bancorp International Group Inc (fka BCIT)

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Third Circuit Sends 'Naked' Short Sale Case to State Court


By Charles Toutant Published: Nov 11, 2014


The U.S. Court of Appeals for the Third Circuit has remanded to New Jersey state court a suit claiming Merrill Lynch, UBS Securities, E Trade Capital Markets and other financial institutions conspired to conduct abusive “naked” short sales of the stock of Escala Group Inc.

The appeals court found no federal jurisdiction over the plaintiffs’ state-law claims, which allege that the defendants manipulated the stock price. Although the short sales at issue in the case are subject to federal scrutiny under Regulation SHO, which has no analogous provision under New Jersey law, the question of whether the defendants’ acts violate New Jersey law need not be answered by reference to Regulation SHO, the appeals court said.

A group of individuals and business entities filed the suit in Morris County Superior Court, and Merrill Lynch removed it to federal court in Newark on federal question jurisdiction. When the plaintiffs moved to remand the case to state court, U.S. Magistrate Judge Michael Hammer recommended the motion be granted in December 2012. But U.S. District Judge Jose Linares overruled Hammer in March 2013 and denied the plaintiffs’ motion to remand.

On Nov. 10, Third Circuit Judges D. Brooks Smith, Thomas Vanaskie and Dolores Sloviter reversed Linares’ ruling and instructed that the case be remanded to the Superior Court of New Jersey.

The ruling is precedential because it marks the first time any federal appeals court has ruled on the interplay between state causes of action and federal claims rising out of a racketeering suit, according to Neil Flaster, the Florham Park, N.J., solo representing the plaintiffs.

The suit was brought by Greg Manning of Boonton, N.J., and Claes Arnrup of Sweden, as well as four holding companies. All held stock in Escala Group at the time of the alleged naked short selling in 2006 and 2007. Escala Group changed its name to Spectrum Group International in 2009. Located in Irvine, Calif., the company is a dealer and auctioneer of stamps, coins, military memorabilia and other collectibles.

Besides Merrill Lynch, UBS and E Trade, the suit names Knight Capital Americas, National Financial Services and Citadel Derivatives Group as defendants. The suit claims the defendants falsified documentation of trades and loans of Escala shares while conducting transactions on their own behalf and for others.

The suit claims the defendants’ actions caused an artificial increase in the number of shares in Escala by “manufacturing fictitious and unauthorized phantom shares,” which caused the value of the plaintiffs’ holdings to decline and diluted their voting rights. The suit brought claims under the New Jersey Racketeer Influenced and Corrupt Organizations Act based on predicate acts of New Jersey securities fraud and theft, and 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.

The suit says that when the naked short sales began in March 2006, the price of Escala stock fell from $32 to $4 in the course of five days.

Smith wrote for the appeals court that in a typical short sale, the seller identifies a stock that is expected to drop in price; arranges to borrow shares of the stock from a broker; sells the borrowed securities; waits for the stock to decrease in value; purchases replacement securities; and returns them to the broker.

Typically, Smith wrote, a short sale is completed within three days, but in a “naked” short sale, the buyer fails to deliver securities to the buyer within the standard three-day settlement period, as part of a scheme to manipulate the price of a stock.

Naked short selling is not per se illegal under federal law, but some naked short selling schemes may violate federal antitrust laws, as well as Regulation SHO, he said.

The defendants argued that federal jurisdiction was conferred by 28 U.S.C. 1331 and by Section 27 of the Exchange Act. In support of their Sec. 1331 claim, the defendants cited D’Alessio v. New York Stock Exchange. In that 2001 case, the Second Circuit found federal jurisdiction under Sec. 1331 where a court was required to construe federal securities laws because the plaintiff claimed the New York Stock Exchange failed to perform its statutory duty, created under federal law, to enforce members’ compliance with those laws. But the present case “is distinguishable because plaintiffs’ claims could rise or fall entirely based on the construction of state law,” the panel said.

The panel also rejected the defendants’ claim of federal jurisdiction under Section 27, which relied on a line of cases from the Ninth Circuit. Those cases are at odds with the Supreme Court’s 1961 decision in Pam American Petroleum Corp. v. Superior Court of Delaware, the panel said.

Plaintiff lawyer Flaster said he was pleased with the decision, since his clients would have been held to a higher standard on a defense motion to dismiss in federal court.

A Merrill Lynch spokesman, Bill Halldin, said the company had no comment about the ruling. Lawyers for the other defendants either did not return calls from a reporter or had no comment. Sophie Sohn, a spokeswoman for KCG, a successor by merger to Knight Capital, said her company had no comment.


http://www.law.com/sites/articles/2014/11/11/third-circuit-sends-naked-short-sale-case-to-state-court