Pet Quarters v. Depository Trust and Clearing

• Decision Date: 09 March 2009
• Docket Number: No. 08-2114.,08-2114.
• Citation: 559 F.3d 772
• Parties: PET QUARTERS, INC.; Clyde A. Jester, an individual; Michael Parnell, an individual; Walter D. O'Hearn, Jr., an individual; Demetri Betzios, an individual, Plaintiffs-Appellants, v. DEPOSITORY TRUST AND CLEARING CORPORATION; Depository Trust Company; National Securities Clearing Corporation, Defendants-Appellees, North American Securities Administrators Association, Incorporated, Amicus on Behalf of Appellant, Securities and Exchange Commission, Amicus on Behalf of Appellee.
• Court: U.S. Court of Appeals — Eighth Circuit

559 F.3d 772

PET QUARTERS, INC.; Clyde A. Jester, an individual; Michael Parnell, an individual; Walter D. O'Hearn, Jr., an individual; Demetri Betzios, an individual, Plaintiffs-Appellants, v. DEPOSITORY TRUST AND CLEARING CORPORATION; Depository Trust Company; National Securities Clearing Corporation, Defendants-Appellees, North American Securities Administrators Association, Incorporated, Amicus on Behalf of Appellant, Securities and Exchange Commission, Amicus on Behalf of Appellee.

No. 08-2114.

United States Court of Appeals, Eighth Circuit.

Submitted: January 16, 2009.

Filed: March 9, 2009.

Scott K. Attaway, argued, Washington, DC (David Charles Frederick, Washington, DC, James W. Christian, Sean F. Greenwood, Scott R. Link, Houston, TX, John R. Knight, Memphis, TN, on the brief), for Appellant.

Gregg M. Mashberg, argued, New York, N.Y. (Peter G. Kumpe, Little Rock, AR, Karen D. Coombs, Charles S. Sims, New York, NY, on the brief), for Appellee.

Rex A. Staples, Stephen W. Hall and Lesley M. Walker, Wachington, DC, on the brief, for Amicus.

Before MURPHY and SMITH, Circuit Judges, and LIMBAUGH¹, District Judge.

MURPHY, Circuit Judge.

Pet Quarters, Inc., a pet supply business, and several of its shareholders (collectively Pet Quarters) filed this damages action in Arkansas state court against Depository Trust and Clearing Corporation 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 seeks $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 (the Commission) 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 court² granted their subsequent motion to dismiss. Pet Quarters appeals, and we affirm.

I.

Pet Quarters claims 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. Because there is generally a lag of several days between the trade date and the delivery or settlement date, the seller profits if the share price drops and the seller is able to purchase shares for delivery at a price lower than the amount for which it agreed to sell.

Short sales can be interpreted by investors as an indication that the share price of a stock will decline, and in some cases may actually cause the decline. 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.³ Pet Quarters sued the outside financiers whom it alleges engaged in a death spiral financing scheme against it in a different case now stayed for arbitration, Pet Quarters, Inc. v. Badian, et al., No. 4:04-CV-697 (E.D.Ark.). In the case before our court, Pet Quarters alleges that the Stock Borrow Program (the program) created and operated by the defendants with the approval of the Commission facilitated the death spiral financing scheme which damaged the value of its stock.

DTC and NSCC are wholly owned subsidiaries of the holding company Depository Trust and Clearing Corporation, 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.

Until 1975 stock sales involved delivery of the physical stock certificates to the buyer, typically through a web of brokers and dealers. As trading volumes increased and systems for clearing and settling stock transactions multiplied, physical transfer of stock certificates became impractical. In 1975 Congress added Section 17A to the Securities Exchange Act of 1934, which directed the Commission "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. 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. UCC § 8-101. A security entitlement is a property interest entitling the holder to exercise all of the rights attached to the security. See UCC § 8-501(b), cmt. 1.

Section 17A also authorized the Commission to register and regulate clearing agencies. Two of the agencies registered and regulated by the Commission under this authority are defendants DTC and NSCC. DTC is the nation's principal securities depository; its nominee Cede & Co. is the direct holder of stock certificates for all of its members which include most securities brokers and dealers in the country and NSCC. DTC's automated system tracks transfers of indirect security entitlement positions among its members, eliminating the need to transfer the physical stock certificates.

NSCC provides centralized clearance, settlement, and information services for virtually all securities transactions in the United States. When a security's ownership changes hands, NSCC acts as the intermediary between buyer and seller. It verifies the transaction information and assumes the rights and obligations of buyers and sellers to receive, pay for, and deliver securities. NSCC Rules & Procedures, Rule 11 §§ 1(b)-(c),(e), Procedure VII(A). NSCC clears the trades through its continuous net settlement system, which nets each member's purchases and sales of a given security at the end of each day. For example, the NSCC account for a member who purchased 800 shares and sold 1800 shares of Pet Quarters in one day would reflect a net obligation to deliver 1000 Pet Quarters shares to NSCC. NSCC Rules & Procedures, Procedure VII(c)(1).

At the close of business on the settlement date, typically three days after the trade date, NSCC instructs DTC to deliver securities from the selling member's DTC account to NSCC's account to satisfy the obligation. On that same date, NSCC instructs DTC to deliver securities from its account to the accounts of those members who made net purchases of a security on a given trade date and therefore have the right to receive security entitlements from NSCC. See NSCC Rules & Procedures, Rule 11 §§ 3-4.

In theory these transactions should be completed in one day, but sometimes a member "fails to deliver" shares of a security to NSCC because it does not have the shares in its DTC account. There can be several reasons for this failure, including administrative problems or uncovered "naked short sales." In a "covered short sale," the seller offers to sell a security he does not own but arranges to borrow the security from a broker to meet his potential delivery obligation. If someone buys the offered shares, the seller delivers the borrowed shares to the buyer and then purchases shares in the same entity to return to the broker within the agreed time period. In a naked short sale, however, the seller offers to sell a security which he does not own and has not arranged to borrow. In some cases the seller will not deliver the security by the settlement date; this failure to deliver leaves the seller with an open position.

Before 1981, a buyer who was the victim of a failure to deliver could wait for the seller to cure the failure through delivery, or could buy the stock on the open market and charge the seller for the difference between the agreed price and the price the buyer paid in the market. NSCC created the automated Stock Borrow Program in 1981 to cover such failures to deliver. 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 Commission under its Section 17A authority.

According to the Stock Borrow Program rules, a member who wishes to participate in the program notifies NSCC daily which securities it has on deposit at DTC that it is making available to the program. If a seller fails to deliver shares of a security by the settlement date, NSCC's account will not have enough shares to meet all of its delivery obligations. In that situation, the program automatically borrows shares from loaning members and covers the sale without the buyer ever knowing that a failure to deliver has occurred. The DTC system records a book entry increasing the buyer's security entitlement position, and the buyer receives all voting and trading rights as with a normal purchase.

Pet Quarters alleges that the Stock Borrow Program created "phantom shares" which diluted the value of its stock because the shares were credited to the buyer's account without being debited from the loaning member's account. According to the program rules, however, the loaning member's account restricts the borrowed shares, and the lending member may not sell or relend the shares until they are returned. NSCC Rules add. C(4). The borrowed shares are returned to the loaning member automatically when there is a net daily gain in deliveries of the stock to NSCC, i.e., when more shares of the borrowed stock...