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‘Naked’ short sellers squeezed by Supreme Court

In a sweeping blow to Wall Street investment giants, the U.S. Supreme Court today unanimously allowed lawsuits against "naked" short sellers in state courts to proceed.

The high court ruled unanimously that shareholders are not confined to federal court when seeking recourse for securities violations. Granting “due deference to the important role of state courts,” the Court reinforced federalist principles while clarifying congressional intentions to limit the federal government’s role.

The ruling, which could give a new boost to startups and small companies targeted by short sellers, showed a rare moment of ideological agreement in the court. Justice Elena Kagan authored the Court’s opinion, and Justice Clarence Thomas, joined by Justice Sonia Sotomayor, issued a concurrence.

In 2012, businessman Greg Manning sued Merrill Lynch and other financial institutions in New Jersey state court for purposefully devaluing his company through systematic “naked” short-selling — a term used to describe selling a stock a seller does not own and has not borrowed. In standard short sales, traders either borrow a stock or make sure that it can be borrowed prior to selling it short in the hope that its value will fall before the transaction must be covered.

The practice has come under increasing scrutiny and has been banned in Germany and other major economies. 

Manning, the CEO of the memorabilia company Escala Group, Inc., owned two million shares of the company, which formerly traded on the NASDAQ and is now known as Spectrum Group International, Inc.

Manning’s claims against the financial institutions include the New Jersey Racketeer Influenced and Corrupt Organizations (RICO) Act along with 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. Today’s ruling will allow Manning to have his day in New Jersey state court.

“Respondents allege that ‘[t]he SEC has expressly noted that naked short selling involves the omission of a material fact' as part of their state-law securities fraud allegation,” Thomas wrote in his concurrence. "Vindicating that claim would not require the enforcement of a federal duty or liability. New Jersey law encompasses fraudulent conduct that does not necessarily rest on a violation of federal law or regulation.”

The ruling comes amid increasing scrutiny of the controversial practice at local and federal levels. After the 2008 financial correction, the Securities and Exchange Commission (SEC) tightened regulation of short-selling.

"False rumors can lead to a loss of investor confidence," the commission reported at the time. "Such loss of investor confidence can lead to panic selling, which may be further exacerbated by ‘naked’ short-selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process. If significant financial institutions are involved, this chain of events can threaten disruption of our markets.”

Manning isn’t the first to claim investment firms colluded to devalue his company’s stock. In 2007, internet retail giant Overstock.com Inc. argued financial institutions deliberately schemed to devalue shares through naked short sales. Although Overstock faced similar jurisdictional hurdles throughout a nine-year battle, Goldman Sachs Group Inc. and Merrill Lynch Professional Clearing Corporation eventually settled RICO and securities fraud claims with the company.

While legitimate short-selling remains an accepted financial practice, manipulation by false rumors and naked short-selling has taken a serious toll on emerging industries. Biotechnology industry insiders have for years pleaded with the SEC to block the illegal short selling and false whisper campaigns that plague the industry. Smaller technology-driven companies frequently lack the resources to deal with attacks that drive down stock prices, crippling research and development budgets.

Monday's ruling could strengthen smaller innovative companies that are not situated to challenge investment institutions at the federal level.