Wall Street Faces New Front for Lawsuits After Supreme Court Ruling

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Tourist visit the Supreme Court Building as a guard stands watch on Aug. 20, 2014 in Washington.

Photo by Mark Wilson/Getty Images
  • Decision on naked short case seen opening door for state suits
  • Ruling could apply to other securities-law cases, lawyer says

The U.S. Supreme Court dealt a blow to financial services firms trying to fend off allegations that they facilitate illegal short selling, affirming the rights of investors to make their case in plaintiff-friendly state courts.

With the court’s ruling on Monday, plaintiffs may find that such suits have a greater chance of advancing in a state court, potentially exposing brokerages to more expensive litigation, said Sam Lieberman, a partner at Sadis & Goldberg LLP.

“It’s easier to have your case thrown out for procedural reasons in federal court,” Lieberman said. “In state courts, you’re more likely to get closer to trial, and get closer to trial means you’re more likely to get closer to settling.”

New Jersey and other states also have Racketeer Influenced and Corrupt Organizations Act statutes aimed at organized crime that could be applied broadly enough to cover the conduct of financial services firms, said David Zaring, a professor of legal studies and business at University of Pennsylvania’s Wharton School of Business.

“New Jersey’s RICO statute might look like an easier route to a jury,” he said.

Siding With Investors

In a unanimous ruling Monday, the Supreme Court sided with investors who sued Bank of America Corp.’s Merrill Lynch and other brokerage firms. At issue was whether the plaintiffs, who alleged they lost money because of the brokers’ involvement in illegal short selling, could use New Jersey state court to sue over their losses -- even if the litigation cited federal laws.

The ruling forces Merrill Lynch, Bank of America’s corporate and investment banking division, and other firms to mount a defense in New Jersey state court. The plaintiffs in the case are using the state’s RICO statute as part of their complaint.

While concerned with so-called naked short selling, the ruling could potentially be applied in other securities matters, said Gary Aguirre, a former SEC enforcement attorney with Aguirre Law APC in San Diego. Plaintiffs may get a fuller airing in such cases in state courts than they would in federal venues, other attorneys said.

‘Crack in the Door’

“Naked short cases have been slaughtered in federal courts,” Aguirre said. “Now there’s a crack in the door. But plaintiff lawyers will have to do a lot of creative designing in state courts to open it further.”

Bank of America Merrill Lynch said it believes the underlying lawsuit is without merit. “We will defend against the substantive allegations in state court where we already have filed for dismissal,” said spokesman Lawrence Grayson.

In the suit, filed four years ago, investors in Spectrum Group International Inc. -- a dealer of precious metals and collectibles formerly known as Escala Group Inc. -- blame Merrill Lynch and other brokerages for helping to drive down the company’s market capitalization by $800 million over 11 months by aiding naked short sellers whose bets against the company pushed down the value of its shares.

A short sale is a way of using borrowed shares to bet that a stock or other security will fall in price; in a naked short, the trader never borrows the shares needed to complete the transactions.

The Securities and Exchange Commission’s Regulation SHO seeks to restrict investors’ ability to short stocks that haven’t been borrowed, in order to restrict the supply and prevent price manipulation. 

Narrow and Technical

While that regulation makes it illegal to use naked short sales to manipulate a security, cases against the practice haven’t fared well in federal court, attorneys said. That’s in part because the Supreme Court has required plaintiffs in federal court to cite specific statutes that they believe have been violated, Wharton’s Zaring said.

Under the Supreme Court’s latest ruling, plaintiff attorneys would still have to bring suits in jurisdictions with applicable anti-fraud or securities laws -- which also include California and Georgia -- and avoid conflicts with federal statutes, Aguirre said. 

The case is Merrill Lynch v. Manning, 14-1132.

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