Eighth Circuit Affirms Dismissal of $400M Short-Selling Suit Against DTCC

Holding:

The U.S. Court of Appeals for the Eighth Circuit has affirmed the dismissal of a $400 million damage suit filed by Pet Quarters, Inc. (“Pet Quarters”) against defendants. Deposit Trust and Clearing Corp. (“DTCC”) and its subsidiaries. Pet Quarters originally filed before the Arkansas state court this damages suit, asserting that defendants, which handle the clearing and settlement of securities in the U.S., were engaged in a short-selling conspiracy through its loan-borrow program. Defendants successfully removed the case to the U.S. District Court for the Eastern District of Arkansas on the basis of federal preemption. The district court granted their subsequent motion to dismiss. On appeal, the Eighth Circuit agreed with the district court’s holding that the case should be dismissed on the basis of preemption. Specifically, the Eighth Circuit held that all of the damages that Pet Quarters claimed to have suffered stemmed from activities performed or statements made by the defendants in conformity with the program's rules that were approved by the Securities and Exchange Commission (“SEC”). A favorable ruling on any of them would conflict with the SEC's control of the national securities clearing and
settlement system and pose an obstacle to the congressional objectives in Section 17A of the Securities Exchange Act of 1934 (“Exchange Act”).

Detailed Summary:

As an overview, Pet Quarters, pet supply business, and several of its shareholders (collectively “Pet Quarters”) filed this damages action in Arkansas state court against DTCC and its subsidiaries, Depository Trust Company (“DTC”) and National Securities Clearance Corporation (“NSCC”), self regulated organizations registered pursuant to Section 17A amendments to the Securities Exchange Act of 1934 (Section 17A). 15 U.S.C. § 78q-1.

Pet Quarters sought $400 million in compensatory damages and punitive damages under state law, alleging that a program created and operated by the defendants with the approval of the Securities and Exchange Commission (“SEC”) permits “naked short selling” which drove down the market price for its shares and eventually put it out of business.

Defendants removed the case to federal court on the basis of federal preemption, and the district court granted their subsequent motion to dismiss.  Hence, they filed this appeal.

Pet Quarters specifically claimed it fell victim to a “death spiral” financing scheme by predator investors while it was trying to implement a capital intensive business plan. As a small company it was susceptible to manipulation and control of its share price by investors who allegedly sold its shares “short.” A short sale occurs when investors offer to sell shares which they do not own for less than the current trading price. Successful death spiral investors deliberately push down the share price of a stock through short selling to profit from the decline. Such actions can eventually make the shares worthless.

Pet Quarters sued the outside financiers whom it alleged engaged in a death spiral financing scheme against it in a different case now stayed for arbitration. Opinion, p. 3, citing Pet Quarters, Inc. v. Badian, et al., No. 4:04-CV-697 (E.D. Ark.).

In the case at bench, Pet Quarters alleged that the Stock Borrow Program (“Program”) created and operated by the defendants with the approval of the SEC facilitated the death spiral financing scheme which damaged the value of its stock.

DTC and NSCC are wholly owned subsidiaries of the holding company DTCC, which in turn is owned by many financial industry entities including the New York Stock Exchange. DTC and NSCC serve distinct functions, but together they provide more securities settlement and clearing services than any other entity in the world. Opinion, pp. 3-4.

In 1975 Congress added Section 17A to the Exchange Act, which directed the SEC “to facilitate the establishment of a national system for the prompt and accurate clearance and settlement of transactions in securities,” and to eliminate the physical movement of securities certificates among brokers and dealers. Id., citing 15 U.S.C. §§ 78q-1(a)(2)(A)(i), (e).

Under the new system securities may be held directly through possession of a stock certificate or entry on the issuer’s stock registry or indirectly by acquisition of a “security entitlement” from an intermediary such as a clearing company, bank, or broker dealer. Id., citing UCC § 8-101. A security entitlement is a property interest entitling the holder to exercise all of the rights attached to the security. Id., citing UCC § 8-501(b), cmt. 1.

Section 17A also authorized the SEC to register and regulate clearing agencies. Two of the agencies registered and regulated by the SEC under this authority are defendants DTC and NSCC. DTC is the nation’s principal securities depository. NSCC provides centralized clearance, settlement, and information services for virtually all securities transactions in the United States.

NSCC created the automated Program in 1981 to cover failures to deliver securities. Under this program the seller can electronically borrow the number of shares of undelivered stock from other members’ accounts and deliver the borrowed shares to the purchaser. The rules governing the program were developed by NSCC and approved by the SEC under its Section 17A authority. Id., pp. 5-6.
Pet Quarters’s complaint included sixteen state law claims. After the case was removed, the district court concluded that the complaint presented substantial federal questions and dismissed it with prejudice, concluding that any attempt to amend would be futile. The district court concluded that claims 9 through 16, including market manipulation, illegal tying, conversion and conspiracy, were preempted because they amounted to direct, facial attacks on the operation of the SEC-approved program and that claims 1 through 8, alleging various misrepresentations, were preempted because they attacked elements of that program.

On appeal, the Eighth Circuit affirmed. In Claims 2 and 6, for example, Pet Quarters alleged that the defendants represented that “they efficiently clear and settle trades” when in fact the program does not efficiently clear and settle trades because it allows failures to deliver to remain open for extended periods. One of the SEC-approved program rules states, “In order to improve the efficiency of the clearing system in dealing with [open positions], the [NSCC] Board has authorized the implementation of (the Stock Borrow Program).” Id., p. 12.

The Eighth Circuit held that the district court did not err in deciding that these claims are preempted because they seek a determination from a state fact-finder that a program declared efficient in rules approved under federal law was in fact not. Id., citing Whistler Invests., Inc. v. Depository Trust & Clearing Corp., 539 F.3d 1159 (9th Cir. 2008).

In claims 3 and 7 of its complaint, Pet Quarters alleged that the defendants misrepresented the number of its shares that a lending member has on account with DTC and NSCC after it loans shares to the program because that number is not reduced, inflating the total number of shares actually held (its phantom shares argument). The methods of accounting for loaned shares are described in detail in the Commission approved program rules, NSCC Rules add. C(4).

According to the Eighth Circuit, court did not err in concluding that these claims were preempted because they amount to a direct challenge to the operation of the SEC- approved program.

In short, all of the damages that Pet Quarters claimed to have suffered stemmed from activities performed or statements made by the defendants in conformity with the program’s SEC-approved rules. The Eighth Circuit concluded that a favorable ruling on any of them would conflict with the SEC’s control of the national securities clearing and settlement system and pose an obstacle to the congressional objectives in Section 17A.

Thus, the district court did not err in dismissing the complaint on the basis of preemption. The Eighth Circuit likewise held that the district court did not err or abuse its discretion in concluding that amendment would be futile and in dismissing with prejudice.

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