New Jersey's other short selling.

Photographer: Don Emmert/AFP/Getty Images

Naked Shorts at the Supreme Court

Noah Feldman is a Bloomberg View columnist. He is a professor of constitutional and international law at Harvard University and was a clerk to U.S. Supreme Court Justice David Souter. His books include “Cool War: The Future of Global Competition” and “Divided by God: America’s Church-State Problem -- and What We Should Do About It.”
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When you’re trading securities, you generally think about being regulated by the Securities and Exchange Commission and federal law. Should you be worried about state law, too? That question isn't merely theoretical, as shown by the naked short selling case that was argued Tuesday before the U.S. Supreme Court. The answer has practical consequences for traders of all kinds.

The case, Merrill Lynch v. Manning, arises from allegations by individual shareholders in Escala Group Inc., that traders at Merrill Lynch, Knight Equity Markets and UBS Securities, among others, engaged in naked short selling to manipulate the value of the stock. In essence, the original plaintiffs alleged that the traders made short sales without bothering to borrow the securities that would be needed to cover the trade.

That's illegal -- sort of. No federal or state law directly criminalizes naked short selling. However, an SEC rule called Regulation SHO says a broker-dealer must have “reasonable grounds” to believe that it could borrow and deliver the security within three days. If the broker-dealer fails to deliver for 13 days, the regulation imposes a “close out” duty to purchase and deliver securities “of like kind and quantity.”

Given that federal law doesn't obviously impose a clear form of liability for naked short selling, the plaintiffs in the case went to New Jersey state court instead. They alleged violations of the state's RICO law, the one designed to outlaw conspiracies of the kind traditionally used by organized crime. RICO laws require specification of particular legal violations; the plaintiffs said the defendants had committed acts of securities fraud and theft under New Jersey law. For good measure, they also said the defendants were liable under New Jersey’s unwritten common law for breach of contract, negligence and other assorted claims.

To explain to the state court what the broker-dealers had done wrong, the plaintiffs described federal Regulation SHO, which they said the defendants had violated. But they were careful to say that their state law case didn't depend on there being a violation of the federal regulation.

Lawyers for Merrill Lynch and the other defendants did what any lawyer would’ve done under the circumstances: They sought to move the case to federal court, where they’d be able to argue that federal law controls naked short selling and that they hadn’t broken it. A federal district court said the case belonged in federal court. But the U.S. Court of Appeals for the 3rd Circuit disagreed, and the case ended up before the Supreme Court.

Who's right? The best argument for allowing the case to go forward in state court is that state securities regulations have been around since long before there was an SEC. The Securities Exchange Act of 1933 was famously drafted over the weekend of April 8, 1933, in a hotel room by the dream team of Thomas Corcoran, Benjamin Cohen and James Landis, three brilliant students of Felix Frankfurter who followed his marching orders in drafting legislation for Franklin Roosevelt’s administration.

By then, every state but Nevada had enacted some version of a general law prohibiting deceptive securities practices. These state laws are called “blue sky laws,” because, as the Supreme Court put it in 1917, they outlaw “speculative schemes which have no more basis than so many feet of ‘blue sky.’”

Congress never said that it was displacing the states’ blue sky laws, which strongly implies that it should still be possible to go to state court in a securities case where federal law doesn’t cover the precise situation.

The strongest counterargument is that it’s highly inefficient to subject securities regulation to the laws of 50 states plus federal law. A national industry requires national standards. Compliance costs are high enough without requiring broker-dealers to worry about divergent regulations in different places.

What makes it tricky to predict the outcome in this case is that the usual liberal and conservative positions produce contradiction.

Generally, the liberals on today’s court like centralized national regulation and favor federal law. So you’d expect them to want to say that this is a federal issue that belongs in federal court.

But that would be a pro-defendant ruling in this case, because Merrill Lynch and the other defendants would probably get a more sympathetic hearing from a federal court, which could find they aren’t liable under federal law. That’s awkward for the liberals, because it makes them look soft on stock manipulators. It also makes them look as if they’re siding with the banks against the little guy, which the liberals hate to do.

For the conservatives, the problem is that respecting state law, the federalist position, puts them in a position of helping pesky plaintiffs’ lawyers who, conservatives believe, are trying to harass defendants for money. The court’s conservatives dislike and distrust plaintiffs’ side securities lawyers, and won’t want to give them the tool of going to state court. They think such litigation adds costs and inefficiency without improving securities markets.

Given the dual tension, my instinct is that the conservatives will win and the lawsuit will be allowed to go forward. But this one will be close -- so call your compliance officer today. He or she may be your best friend.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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