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SUPREME COURT OF THE STATE OF NEVADA

NANOPIERCE TECHNOLOGIES, INC.,

a Nevada Corporation; STEPHEN SEITZ,

an individual; JANE SEITZ, an individual;

KATHY KNIGHT-MCCONNELL, an

individual; JAMES STOCK, an individual;

MAUREEN O’SULLIVAN, an individual;

and HELEN KOLADA, an individual,

SUPREME COURT

CASE NO. 45364

DISTRICT COURT

CASE NO. CV04-01079

Appellants,

vs.

THE DEPOSITORY TRUST AND CLEARING

CORPORATION; THE DEPOSITORY TRUST

COMPANY; AND THE NATIONAL

SECURITIES CLEARING CORPORATION,

Respondents.

________________________________________/

BRIEF OF THE SECURITIES AND EXCHANGE COMMISSION,

AMICUS CURIAE, ON THE ISSUE ADDRESSED

JACOB H. STILLMAN

Solicitor

MARK PENNINGTON

Assistant General Counsel

MICHAEL L. POST

Senior Counsel

(Pursuant to Nev. S. Ct. R. 43)

Securities and Exchange Commission

100 F St. NE

Washington, DC 20549-8010

(202) 551-5194 (Post)

TABLE OF CONTENTS

Page

TABLE OF AUTHORITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii

INTEREST OF THE SECURITIES AND EXCHANGE COMMISSION . . . . . . 1

ISSUE ADDRESSED BY THE COMMISSION . . . . . . . . . . . . . . . . . . . . . . . . . 2

BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Section 17A of the Exchange Act charges the Commission

with overseeing the national clearance and settlement

system in accordance with the public interest and the

protection of investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

The Stock Borrow Program is designed to improve the

efficiency of the continuous net settlement system by

increasing the likelihood that purchasers will receive

their securities on settlement date. . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

The Continuous Net Settlement system . . . . . . . . . . . . . . . . . . 8

Buy-ins to satisfy delivery obligations when

members fail to deliver securities . . . . . . . . . . . . . . . . . . . . . . 10

The Stock Borrow Program . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Plaintiffs’ incorrect descriptions of important

aspects of the Continuous Net Settlement system

and the Stock Borrow Program . . . . . . . . . . . . . . . . . . . . . . . 13

The Commission has approved the Stock Borrow Program

as being in compliance with the Requirements of the

Exchange Act. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

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TABLE OF CONTENTS (CONTINUED)

Page

ARGUMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

State laws that conflict with federal regulatory regimes

are preempted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Permitting state law liability for the conduct alleged in

the complaint would conflict with the Exchange Act regulatory

regime. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Plaintiffs’ direct challenges to the Stock Borrow

Program are preempted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Plaintiffs’ so-called “misrepresentation” claims are

also preempted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

There are remedies for manipulations perpetrated by naked

short sellers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

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TABLE OF AUTHORITIES

Cases

Page

Bradford National Clearing Corp. v. SEC, 590 F.2d 1085

(D.C. Cir. 1978) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3, 8

Credit Suisse First Boston Corp. v. Grunwald,

400 F.3d 1119 (9th Cir. 2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Crosby v. National Foreign Trade Council, 530 U.S. 363 (2000) . . . . . . . . . . . . 19

Merrill Lynch, Pierce, Fenner & Smith v. Ware,

414 U.S. 117 (1973) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20, 26

Savage v. Jones, 225 U.S. 501 (1912) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Commission Releases

In the Matter of the Full Registration as Clearing Agencies of The

Depository Trust Co. et al., SEC Rel. No. 34-20221,

48 Fed. Reg. 45167 (Oct. 3, 1983) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3, 8, 17, 18

passim

Issuer Restrictions or Prohibitions on Ownership by Securities

Intermediaries, 69 Fed. Reg. 70852 (Dec. 7, 2004) . . . . . . . . . . . . . . . . . . . . . . 28

Order Granting Approval of a Proposed Rule Change Concerning

Requests for Withdrawal of Certificates by Issuers,

SEC Rel. No. 34-47978, 68 Fed. Reg. 35037 (June 11, 2003) . . . . . . . . . . . . . . 28

Regulation SHO Proposing Release, SEC Rel. No. 34-48709,

68 Fed. Reg. 62972 (Nov. 6, 2003) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Short Sales, SEC Rel. No. 34-50103, 69 Fed. Reg. 48008

(Aug. 6, 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28, 29

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TABLE OF AUTHORITIES (CONTINUED)

Commission Releases (Continued)

Page

SEC Rel. No. 34-16514, 45 Fed. Reg. 5867 (Jan. 24, 1980) . . . . . . . . . . . . . . . . 17

SEC Rel. No. 34-17422, 46 Fed. Reg. 3104 (Jan. 13, 1981) . . . . . . . . . . . . . . . . 17

Statutes and Rules

Securities Exchange Act of 1934, 15 U.S.C. 78a, et seq.

Section 3(a)(23)(A), 15 U.S.C. 78c(a)(23)(A) . . . . . . . . . . . . . . . . . . . . . . . 5

Section 3(a)(26), 15 U.S.C. 78c(a)(26) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Section 17A, 15 U.S.C. 78q-1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1, 3

passim

Section 17A(a)(1), 15 U.S.C. 78q-1(a)(1) . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Section 17A(a)(2), 15 U.S.C. 78q-1(a)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Section 17A(b), 15 U.S.C. 78q-1(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Section 17A(b)(1), 15 U.S.C. 78q-1(b)(1) . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Section 17A(b)(2), 15 U.S.C. 78q-1(b)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Section 17A(b)(3)(A), 15 U.S.C. 78q-1(b)(3)(A) . . . . . . . . . . . . . . . . . . . . . 6

Section 17A(b)(3)(F), 15 U.S.C. 78q-1(b)(3)(F) . . . . . . . . . . . . . . . . . . 6, 23

Section 17A(b)(3)(I), 15 U.S.C. 78q-1(b)(3)(I) . . . . . . . . . . . . . . . . . . . . . . 6

Section 17A(d)(1), 15 U.S.C. 78q-1(d)(1) . . . . . . . . . . . . . . . . . . . . . . . 7, 26

Section 19(b), 15 U.S.C. 78s(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7, 17

Section 19(b)(2), 15 U.S.C. 78s(b)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Section 19(b)(3), 15 U.S.C. 78s(b)(3) . . . . . . . . . . . . . . . . . . . . . . . . . . 7, 16

Section 19(c), 15 U.S.C. 78s(c) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Miscellaneous

Responses to Frequently Asked Questions Regarding SHO (Jan. 3, 2005),

http://www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm . . . . . . . . . . . . . 15

UCC Sections 8-104, 8-501 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

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INTEREST OF THE SECURITIES AND EXCHANGE COMMISSION

The national clearance and settlement system for securities plays a crucial

role in our nation’s capital markets. National Securities Clearing Corporation

(NSCC), one of the defendants in this case, provides clearing services for virtually

all broker-to-broker equity and corporate debt trades in the United States, clearing

over 20 million equity transactions on an average trading day. Because of the

importance of the effective performance of this system, Congress requires clearing

agencies to be registered with the Securities and Exchange Commission and

subject to the Commission’s comprehensive oversight under Section 17A of the

Securities Exchange Act of 1934, 15 U.S.C. 78q-1.

Plaintiffs’ lawsuit threatens to disrupt or to impose substantial and

unwarranted costs on this system by seeking damages against registered clearing

agencies for operation of the NSCC stock borrow program pursuant to

Commission-approved rules. The gravamen of plaintiffs’ complaint is that they

have been injured by a stock manipulation carried out by naked short sellers –

those who sell shares they do not own without borrowing the shares necessary to

make delivery. Yet plaintiffs sue here, not the short sellers, but these defendants,

despite plaintiffs’ concession that defendants are acting in compliance with

applicable rules.

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Some of plaintiffs’ claims for relief allege that operation of the stock borrow

program itself gives rise to damage claims, while others are characterized as

“misrepresentation” claims, but both sets of claims are in actuality challenges to

the correctness of the Commission’s decision to approve the stock borrow

program. Thus, a state court award of damages under plaintiffs’ allegations would

create a direct conflict with that decision, and plaintiffs’ case is therefore

preempted by the Exchange Act. As the regulator charged by Congress with

ensuring that the national clearance and settlement system functions efficiently, in

the public interest and for the protection of investors, the Commission has a strong

and direct interest in seeing that the threats created by plaintiffs’ lawsuit are ended

by the affirmance of the district court’s dismissal.

ISSUE ADDRESSED BY THE COMMISSION

Whether the Exchange Act preempts state law claims against registered

clearing agencies either for operating the stock borrow program in accordance

with Commission-approved rules, or for failing to disclose alleged “defects” in

that program, the existence of which would be contrary to the factual basis on

which the Commission approved the program.

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BACKGROUND

Section 17A of the Exchange Act charges the Commission with

overseeing the national clearance and settlement system in

accordance with the public interest and the protection of

investors.

Congress enacted Section 17A of the Exchange Act as part of the legislative

response to the paperwork crisis of the late 1960s and early 1970s. See generally

In the Matter of the Full Registration as Clearing Agencies of The Depository

Trust Co. et al., SEC Rel. No. 34-20221, 48 Fed. Reg. 45167, 45168 (Oct. 3, 1983)

(“Final Approval Order”); Bradford National Clearing Corp. v. SEC, 590 F.2d

1085, 1090-94 (D.C. Cir. 1978).

Section 17A opens with Congressional findings and a general direction to

the Commission to be followed in administering the statute. Congress found that

(A) The prompt and accurate clearance and settlement of securities

transactions, including the transfer of record ownership and the

safeguarding of securities and funds related thereto, are necessary for the

protection of investors and persons facilitating transactions by and acting on

behalf of investors.

(B) Inefficient procedures for clearance and settlement impose unnecessary

costs on investors and persons facilitating transactions by and acting on

behalf of investors.

opportunity for more efficient, effective, and safe procedures for clearance

and settlement.

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(D) The linking of all clearance and settlement facilities and the

development of uniform standards and procedures for clearance and

settlement will reduce unnecessary costs and increase the protection of

investors and persons facilitating transactions by and acting on behalf of

investors.

Section 17A(a)(1), 15 U.S.C. 78q-1(a)(1).

Congress directed the Commission, “having due regard for the public

interest, the protection of investors, and the safeguarding of securities,” to

“facilitate the establishment of a national system for the prompt and accurate

clearance and settlement of transactions in securities * * * in accordance with the

findings and to carry out the objectives set forth” above. Section 17A(a)(2), 15

U.S.C. 78q-1(a)(2).

To achieve these statutory objectives, Section 17A makes it unlawful for a

clearing agency to do business in interstate commerce unless it is registered with

the Commission. Section 17A(b), 15 U.S.C. 78q-1(b). 1 Registration may not be

The term “clearing agency” means

any person who acts as an intermediary in making payments or

deliveries or both in connection with transactions in securities

or who provides facilities for comparison of data respecting the

terms of settlement of securities transactions, to reduce the

number of settlements of securities transactions, or for the

allocation of securities settlement responsibilities. Such term

also means any person, such as a securities depository, who (i)

acts as a custodian of securities in connection with a system for

the central handling of securities whereby all securities of a

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granted unless the Commission finds that both the clearing agency itself and the

clearing agency’s rules meet specified statutory requirements (the

“Requirements”), which implement the broad objectives of the statute. Section

17A(b)(1), 15 U.S.C. 78q-1(b)(1). A clearing agency’s application for registration

must contain the rules of the clearing agency, and such other information as the

Commission requires “as necessary or appropriate in the public interest or for the

prompt and accurate clearance and settlement of securities transactions.” Section

17A(b)(2), 15 U.S.C. 78q-1(b)(2).

A clearing agency is required, among other things, to be so organized, and

have the capacity, to be able to: facilitate the prompt and accurate clearance and

settlement of securities transactions, safeguard securities and funds in its custody

or control or for which it is responsible, comply with the provisions of the federal

securities laws, enforce compliance by its participants with the rules of the

particular class or series of any issuer deposited within the

system are treated as fungible and may be transferred, loaned,

or pledged by bookkeeping entry without physical delivery of

securities certificates, or (ii) otherwise permits or facilitates the

settlement of securities transactions or the hypothecation or

lending of securities without physical delivery of securities

certificates.

Section 3(a)(23)(A) of the Exchange Act, 15 U.S.C. 78c(a)(23)(A).

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clearing agency, and carry out the purposes of Section 17A. Section

17A(b)(3)(A), 15 U.S.C. 78q-1(b)(3)(A).

The statute imposes both affirmative and negative requirements on clearing

agency rules. Affirmatively, Section 17A requires that those rules be designed to

– promote the prompt and accurate clearance and settlement of securities

transactions,

– assure the safeguarding of securities and funds which are in the custody or

control of the clearing agency or for which it is responsible,

– foster cooperation and coordination with persons engaged in the clearance

and settlement of securities transactions,

– remove impediments to and perfect the mechanism of a national system

for the prompt and accurate clearance and settlement of securities

transactions, and

– in general, to protect investors and the public interest.

Section 17A(b)(3)(F), 15 U.S.C. 78q-1(b)(3)(F).

Negatively, the rules must not be designed to permit unfair discrimination in

the admission of participants or among participants in the use of the clearing

agency, or to regulate by virtue of any authority conferred by the Exchange Act

matters not related to the purposes of Section 17A or the administration of the

clearing agency. Id. Also, the rules must not impose any burden on competition

not necessary or appropriate in furtherance of the purposes of the Exchange Act.

Section 17A(b)(3)(I), 15 U.S.C. 78q-1(b)(3)(I).

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Registered clearing agencies are self-regulatory organizations (SROs) under

the Exchange Act. Section 3(a)(26), 15 U.S.C. 78c(a)(26). Therefore, changes to

a clearing agency’s rules after registration may only be made pursuant to Section

19(b) of the Exchange Act, 15 U.S.C. 78s(b). That section provides that no

change may take effect unless approved by the Commission under Section

19(b)(2), 15 U.S.C. 78s(b)(2), as being consistent with the Exchange Act, or

unless permitted to take effect without prior approval pursuant to Section 19(b)(3),

15 U.S.C. 78s(b)(3).

The Commission also has plenary rulemaking authority with respect to

clearing agency conduct. No registered clearing agency may engage in any

activity as a clearing agency “in contravention of such rules and regulations * * *

as the Commission may prescribe as necessary or appropriate in the public

interest, for the protection of investors, or otherwise in furtherance of the purposes

of” the Exchange Act. Section 17A(d)(1), 15 U.S.C. 78q-1(d)(1).

The Stock Borrow Program is designed to improve the efficiency

of the Continuous Net Settlement system by increasing the

likelihood that purchasers will receive their securities on

settlement date.

In this section, we describe the relevant aspects of the continuous net

settlement system, the procedures for buying-in securities for delivery to

purchasers when sellers fail to deliver securities, and the stock borrow program.

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Also, we correct some of the fundamental errors in plaintiffs’ descriptions of the

continuous net settlement system and the stock borrow program.

1. The Continuous Net Settlement system

The securities that are the subject of the complaint were deposited at

defendant The Depository Trust Corporation (DTC). DTC accepts deposits of

securities from participants or issuers, credits those securities to participants’

accounts, and transfers securities among those accounts by computerized book-

entry movements pursuant to the participants’ instructions. The securities

deposited at DTC are registered on the books of the security’s issuer in the name

of DTC’s nominee, Cede & Co.

Trades in these securities clear through NSCC’s continuous net settlement

system. See generally NSCC Rule 11, Sec. 1(a); Final Approval Order, 48 Fed.

Reg. at 45170 n.32; Bradford, 590 F.2d at 1091 n.2. 2 Under that system, NSCC

becomes the contra-party to each purchase or sale of securities. NSCC assumes

the obligation of each member that is receiving securities to receive and pay for

those securities, and it assumes the obligation of each member that is delivering

Relevant excerpts of NSCC Rules and Procedures are contained in the

Joint Appendix. The relevant rules can be found at JA Volume 6, pp.

905-11, and the relevant procedures, including Addendum C, can be

found at JA Volume 2, pp. 347-88.

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securities to make the delivery. Rule 11, Secs. 1(b), (c), (e); Procedure VII(A).

NSCC is also assigned the receiving party’s right to receive securities and the

delivering party’s right to receive payment. Id. The assumption of these

obligations and the assignment of these rights place NSCC between the delivering

member and the receiving member – the delivering member is obligated to deliver

securities to NSCC; the receiving member is obligated to pay for securities

delivered by NSCC; and NSCC is obligated to receive and pay for securities from

the delivering member, and to deliver securities to the receiving member. Id.

All member transactions in a given security are netted daily, based on trade

date, so that each member is required to deliver to NSCC or receive from NSCC

only the difference between the total amount of each security that it bought and the

total amount that it sold during the trading period (i.e., purchases are netted

against sales). Procedure VII(C)(1). NSCC rules provide that a member that owes

NSCC securities is described as having a short position, a member that is entitled

to receive securities from NSCC has a long position, and a member that is neither

obligated to deliver nor entitled to receive securities has a flat position. Rule 11,

Secs. 1(a), 2. 3

“Short position” in this context means only that the member has an

obligation to deliver securities to NSCC. It does not mean that the

securities were sold short in the market.

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For each member with a short position in a security on settlement date,

NSCC instructs the securities depository designated by the member (i.e., defendant

Depository Trust Company) to deliver securities from the member’s account at the

depository to NSCC’s account there. Rule 11, Secs. 3, 4; Procedure VII(C)(2).

NSCC then instructs the depository to deliver those securities from NSCC’s

account to members with long positions in the security. Rule 11, Secs. 3, 4;

Procedure VII(C)(3). 4

Sometimes, members fail to deliver to NSCC the total number of securities

that they are obligated to deliver on a particular settlement date, i.e., they do not

have sufficient securities on deposit at their designated depository to eliminate

their short position. Procedure VII(C)(3). 5 In that situation, NSCC uses an

algorithm to allocate the fails to deliver to members who are due to receive

securities. Procedure VII(E). A member’s failure to deliver may cause the

Buy-ins to satisfy delivery obligations when members fail to

deliver securities

Details of the procedures for establishing each member’s position on

settlement date are set forth in Rule 11-5.

Fails-to-deliver may be caused by reasons other than naked short

selling. For example, human or mechanical errors or processing

delays can result from transferring securities in physical certificate

rather than book-entry form, thus causing a failure to deliver on a

long sale within the normal three-day settlement period.

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receiving member to whom the fail is allocated to have a long position, i.e., to be

entitled to receive securities from NSCC.

A member that has failed to receive securities has two options: it may

either maintain that position and wait for delivery to be made to it as securities are

delivered to NSCC, or it may file a Notice of Intention to Buy-in with NSCC.

Rule 11, Sec. 7(a), Procedure VII(J). In response to the filing of such a Notice,

NSCC takes a series of steps to facilitate the buy-in, including, if necessary,

executing the buy-in in the marketplace of its choice, through the agents of its

choosing. Procedure X(A)(1). When a buy-in is executed, any loss incurred in the

purchase is allocated in accordance with NSCC procedures to members with short

positions in the security. Id.

The fact that a broker-dealer that is an NSCC member fails to receive

securities that it purchased on behalf of a retail customer does not mean that the

customer’s purchase is not completed until the member’s failure to receive is

cured. Under Article 8 of the Uniform Commercial Code, a securities broker-

dealer may credit a customer’s account with a security even though that security

has not yet been delivered to the broker-dealer’s account by NSCC. In that event,

the customer receives what is defined under the Uniform Commercial Code as a

“securities entitlement,” which requires the broker-dealer to treat the person for

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whom the account is maintained as entitled to exercise the rights that comprise the

security. See UCC Sections 8-104, 8-501.

3. The Stock Borrow Program

The stock borrow program is intended to improve the efficiency of the

clearance and settlement system by increasing the likelihood that purchasers will

receive delivery of their securities on settlement date even though insufficient

securities have been delivered to NSCC. NSCC Rules, Addendum C. Under the

applicable Rules, the program is automated and operates without the exercise of

discretion by NSCC.

Members wishing to participate in the program as lenders notify NSCC each

day of securities that they have on deposit with DTC that are available to be

borrowed for delivery to receiving members. Id. If NSCC has unsatisfied delivery

obligations on a particular settlement date, it will borrow available securities

according to a formula that allocates the borrowing among members who are

willing to lend. Id. Borrowed securities are entered in a special continuous net

settlement sub-account, and are used to satisfy delivery obligations to members

with long positions who would otherwise fail to receive. The lending member is

credited the market value of the securities borrowed, and the long position in the

member’s account will reflect the borrowing of the shares until those shares are

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returned. Id. Borrowed stock is returned to the lender through normal allocation

in the continuous net settlement system as securities become available. Id.

Alternatively, the lender, as any other member with a long position, may initiate

buy-in procedures by submitting a Notice of Intention to Buy-in. Until the

securities are returned, the lending member no longer has ownership rights in

them, and therefore cannot sell or re-lend them.

Plaintiffs’ incorrect descriptions of important aspects of the

Continuous Net Settlement system and the Stock Borrow

Program

This summary of the applicable NSCC rules makes clear that plaintiffs’

descriptions of the continuous net settlement system and the stock borrow program

are flawed in important respects. Among their erroneous allegations are that (1)

the stock borrow program is the only way that fails to deliver can be cured, (2)

NSCC is at fault for not requiring buy-ins, and (3) the stock borrow program

results in the creation of phantom securities.

First, a receiving member that has failed to receive securities can obtain

those securities through a buy-in that does not involve the stock borrow program

at all.

Second, NSCC does not have the authority to require buy-ins. As noted, its

role in the stock borrow program is automated and non-discretionary -- the only

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entity authorized by the rules to require a buy-in is the receiving member. If a

long position remains open for an extended period of time, that is because the

receiving member has not initiated a buy-in, presumably because that member is

willing to rely on the fact that it will eventually be allocated securities pursuant to

NSCC’s procedures. These statements are true whether the entity that is owed

securities is the original purchaser who did not receive delivery, or a firm that has

loaned securities to the stock borrow program.

Furthermore, NSCC has no mechanism for determining whether particular

fails to deliver have occurred because of illegal naked short selling or for some

legitimate reason. Nor are there any standards or rules that would guide its

discretion in deciding whether to make a buy-in, if it were to undertake do so. In

short, the assertion that NSCC is in some way culpable for failing to initiate buy-

ins is contrary to the clear terms of the Rules.

Third and finally, neither the continuous net settlement system nor the stock

borrow program creates artificial securities. The number of securities issued and

outstanding is determined by the security issuer and is reflected in the issuer’s

records of registered ownership; nothing that happens in the course of clearing and

settling trades, including any action taken by NSCC, can change that number.

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As explained above, the continuous net settlement system is essentially an

accounting system that records delivery and receive obligations among NSCC

members. These obligations do not reflect ownership positions. Ownership

positions, as opposed to the deliver and receive obligations recorded by NSCC, are

reflected on the records of DTC.

The security’s issuer maintains its own record of all of the registered

ownership positions of its securities. All shares deposited at DTC are recorded on

the issuer’s records in the name of DTC’s nominee, Cede & Co., and constitute

some or all of the issuer’s securities issued and outstanding. The fact that

securities settle through the continuous net settlement system, or that they are

deposited at DTC, does not increase the number of the issuer’s shares.

As to the stock borrow program, as noted above and as further explained by

the Commission’s staff in guidance on the Commission’s website, the securities

loaned by NSCC members for use in the program must be on deposit at DTC, and

are debited from members’ accounts when the securities are used to make delivery.

See Responses to Frequently Asked Questions Regarding SHO (Jan. 3, 2005),

http://www.sec.gov/divisions/marketreg/mrfaqregsho1204.htm. Once a member’s

securities are used for delivery to another member, the lending member no longer

-15-

has ownership rights in those securities, which means that it cannot sell or re-lend

them until such time as the securities are returned to its DTC account.

When securities are not available to be loaned through the the stock borrow

program, the buyer is required to either wait for delivery or initiate a buy-in.

Neither waiting nor buying-in increases the number of issued and outstanding

securities. All that the stock borrow program does is shift the consequences of the

failure to deliver from a buyer that has not affirmatively indicated a willingness to

wait for delivery of its securities to a lender that has indicated that it is willing to

wait. This shift cannot possibly increase the number of securities issued, any more

than the buyer’s decision to either wait or initiate a buy-in can do so. Therefore,

plaintiffs’ assertion that the stock borrow program creates securities is incorrect. 6

While the number of securities outstanding does not change because

of the clearance and settlement system, the aggregate number of

positions reflected in customer accounts at broker-dealers may in fact

be greater than the number of securities issued and outstanding. This

is due in part to the fact that, as noted above, broker-dealers may

credit customer accounts with securities entitlements in anticipation

of delivery of the security to the broker-dealer.

-16-

The Commission has approved the Stock Borrow Program as

being in compliance with the Requirements of the Exchange Act.

Defendants NSCC, DTC, and a number of other clearing agencies filed

applications for registration with the Commission in 1976. Final Approval Order,

48 Fed. Reg. at 45168-69. The Commission granted each of these agencies

conditional registration. Id. It then undertook a thorough review of each clearing

agency’s operations and rules to ensure that they met the statutory Requirements

before granting full registration. Id. The Commission also published standards

(the “Standards”) to be used by its Division of Market Regulation in reviewing

and making recommendations concerning whether each clearing agency should be

granted full registration. Id. at 45169.

NSCC adopted the stock borrow program by rule changes that took effect

pursuant to Section 19(b)(3) during the time when it was operating under the

conditional registration. SEC Rel. No. 34-16514, 45 Fed. Reg. 5867 (Jan. 24,

1980) (notice of filing of NSCC proposed rule change adopting as a one year pilot

program procedures for borrowing securities to meet system needs); SEC Rel. No.

34-17422, 46 Fed. Reg. 3104 (Jan. 13, 1981) (notice of filing of NSCC proposed

rule change making pilot program permanent).

The Commission granted NSCC’s application for full registration in 1983,

nearly three years after the stock borrow program rules took effect. 48 Fed. Reg.

-17-

at 45178. After describing its review of NSCC’s application and the extensive

oversight it had exercised over NSCC during the pendency of that application, the

Commission stated that it had determined “that NSCC’s by-laws, rules,

procedures, and systems, as amended, are consistent with the Requirements and

the Standards,” and that accordingly, it “believe[d] that NSCC should be granted

full registration.” Id. 7

ARGUMENT

Plaintiffs are suing defendants for alleged manipulations committed by

naked short sellers. Whether based on direct allegations that operation of the

stock borrow program caused them compensable harm, or on allegations that

defendants made actionable “misrepresentations” by failing to disclose asserted

The Commission relied on each clearing agency’s application, as well

as on the Commission’s continuous monitoring and oversight of the

agencies, including its review of each proposed rule change filed with

it. 48 Fed. Reg. at 45170-71. Specifically,

in carrying out the Commission’s general oversight

responsibilities, the Commission has reviewed, pursuant

to Section 19(b) of the Act, each of the many proposed

rule changes filed by the clearing agencies. Those rule

changes have concerned most of the major services and

systems of each clearing agency, all of the recent

enhancements to clearing agency services, and all

schedules of fees.

48 Fed. Reg. at 45171.

-18-

defects in the program, plaintiffs’ claims conflict with the Exchange Act’s

regulatory regime for registered clearing agencies and with the Commission’s

approval of the rules governing the program. We therefore believe that the district

court was correct in ruling that:

Federal law explicitly permits the [stock borrow program] to operate.

Plaintiffs have not alleged that the NSCC violated any rules

governing [the stock borrow program]. Therefore, state law may not

be applied as to impose damages on Defendants. To do so would be

to forbid the Defendants from doing what the SEC authorized them to

do.

Order, JA 1743.

The balance of this brief explains the basis for our conclusion.

State laws are “naturally preempted to the extent of any conflict with a

federal statute.” Crosby v. National Foreign Trade Council, 530 U.S. 363, 372

(2000). 8 A court will find conflict preemption “where it is impossible for a

private party to comply with both state and federal law, and where under the

State laws that conflict with federal regulatory regimes are

preempted.

In addition to conflict preemption, preemption can also arise when

Congress has expressly preempted state law, and also when Congress

has occupied the field in such a way as to exclude state law.

Defendants have not argued that there is express preemption here, and

because we believe that plaintiffs’ claims are preempted under a

conflict analysis, we do not discuss whether field preemption applies.

-19-

circumstances of a particular case, the challenged state law stands as an obstacle to

the accomplishment and execution of the full purposes and objectives of

Congress.” Id. (internal citations, quotation marks, and brackets omitted). “What

is a sufficient obstacle is a matter of judgment, to be informed by examining the

federal statute as a whole and identifying its purpose and intended effects.” Id. at

373. In Crosby (530 U.S. at 373), the Court quoted Savage v. Jones, 225 U.S. 501,

533 (1912):

For when the question is whether a Federal act overrides a state law,

the entire scheme of the statute must of course be considered and that

which needs must be implied is of no less force than that which is

expressed. If the purpose of the act cannot otherwise be

accomplished – if its operation within its chosen field else must be

frustrated and its provisions be refused their natural effect – the state

law must yield to the regulation of Congress within the sphere of its

delegated power.

law. Credit Suisse First Boston Corp. v. Grunwald, 400 F.3d 1119, 1128 (9th Cir.

2005), citing Merrill Lynch, Pierce, Fenner & Smith v. Ware, 414 U.S. 117, 127

(1973).

SRO rules that are approved by the Commission preempt conflicting state

-20-

Plaintiffs directly challenge the stock borrow program by alleging that

operation of the program in conformity with the applicable rules gives rise to

claims for manipulation (Claim 5), illegal tie-ins (Claim 6), conversion (Claim 19),

intentional interference with contractual relationship (Claim 20), breach of duty of

good faith and fair dealing (Claim 21), and conspiracy (Claim 22). These claims

warrant little discussion, and they are scarcely mentioned in plaintiffs’ brief –

plaintiffs explicitly ask a state court to hold that damages may be awarded against

registered clearing agencies for performing their roles in the national clearance

and settlement system in accordance with Commission-approved rules. The

conflict could not be clearer. Plaintiffs’ assertion that no federal law authorizes

defendants to engage in a manipulation, or impose illegal tie-ins, and so on, is

merely question begging. Any state law that defined defendants’ federally-

approved conduct as falling into any of these forbidden categories of conduct

would be preempted.

Permitting state law liability for the conduct alleged in the

complaint would conflict with the Exchange Act regulatory

regime.

Plaintiffs’ direct challenges to the Stock Borrow Program

are preempted.

-21-

Plaintiffs’ so-called “misrepresentation” claims are also

preempted.

Perhaps recognizing that a state-law based frontal assault on the stock

borrow program is doomed to failure, defendants seek to dress up their claims by

alleging various forms of “misrepresentations.” 9 But this tactic must fail because,

in reality, plaintiffs’ so-called misrepresentation claims, no less than their other

claims, seek to attack the Commission’s approval of the stock borrow program by

holding defendants liable for conducting business in accordance with

Commission-approved rules.

Plaintiffs’ appellate brief concedes that plaintiffs are not alleging that

defendants failed to comply with the relevant NSCC rules in conducting the stock

borrow program (Pltf. Br. at 16). Furthermore, their complaint does not allege that

defendants ever misrepresented the content of those rules, or that they falsely

claimed that they were complying with the rules when they were not. Rather,

plaintiffs in essence argue that defendants are liable for failing to disclose what

Plaintiffs allege that defendants made four misrepresentations about

defects in the way the stock borrow program operates. Each of these

alleged misrepresentations is the basis for four claims for relief, so

that there are a total of sixteen misrepresentation claims: each of the

four misrepresentations is alleged to be a violation of Nevada

statutory law (Claims 1, 2, 3, 4), a negligent misrepresentation

(Claims 7,8,9,10), an intentional misrepresentation (Claims

11,12,13,14) and a fraudulent misrepresentation (15, 16, 17, 18).

-22-

plaintiffs consider to be defects in those rules, or what plaintiffs allege are

undesirable consequences of the rules.

The true nature of plaintiffs’ allegations is made clear in their appellate

brief, when they urge that there can be no conflict preemption here because:

The SEC authorized the creation of the SBP [stock borrow program] only as

that program was proposed and explained by the NSCC. It did not approve

the defects in the SBP – and could not have done so – because the NSCC

did not disclose those defects. Moreover, the SBP was touted by the NSCC

as a mechanism for dealing with temporary, short-term fails-to-deliver. But

as everyone in the financial world but the defendants now acknowledges, it

has become in practice just the opposite in many cases – fails to deliver

frequently remain open for long periods, even indefinitely.

Pltf. Br. at 30 (emphasis in original). In a footnote, plaintiffs further assert that

defendants “vociferously deny that the SBP has the defects alleged in the”

complaint, and that defendants therefore “could not have disclosed those defects to

the SEC during the process by which creation of the SBP was approved, and the

SEC could not – and did not – approve or authorize the program’s defects that are

alleged in the” complaint. Id. at n.16. Plaintiffs go on to claim that the

Commission “did not authorize misstatements about the effect of the SBP, or

approve of failing to disclose those effects to sellers and purchasers of securities”

and that “[a]uthority to implement and operate a program is simply not co-

extensive with a license to misspeak about the nature and effects of the program.”

Pltf. Br. 31.

-23-

According to plaintiffs, in other words, it is the failure to disclose these

alleged “defects” in how the program functions that is the basis for plaintiffs’

misrepresentation claims. Yet when the Commission approved the rules as being

consistent with the statutory Requirements and the Commission-issued Standards,

it thereby found that, among other things, the rules were designed to promote the

prompt and accurate clearance and settlement of securities transactions, remove

impediments to and perfect the mechanism of a national system for the prompt and

accurate clearance and settlement of securities transactions, and, in general, to

protect investors and the public interest. See Section 17A(b)(3)(F).

To establish their fraud claims, plaintiffs would first have to prove either

that the Commission erred when it originally approved the rules governing the

program because the program was defective at that time, or that the program had

become defective at some point during the past twenty years, so that the

Commission erred in not putting a stop to it. Only after the premise that the

program is defective had been established could plaintiffs go to the second step in

their case, which is proving that the defendants committed actionable

misrepresentations by failing to disclose the supposed defects.

Thus, plaintiffs seek to challenge the Exchange Act regulatory regime by

asking a state court, applying state law, to determine that a Commission-approved

-24-

program does not work as the Commission understands it to work, and then to

determine that defendants’ failure to disclose the defects in the program is a form

of fraud, compensable in damages. If accepted, plaintiffs’ theory of liability

would open up any Commission-approved SRO rule to challenges under similar

theories, namely that the Commission erred in approving the rule because it

misapprehended the rule’s consequences, and that the SRO then committed state-

law fraud by failing to disclose the facts that establish the Commission’s error. Of

course, any state law that created this result would make uniform regulation

impossible, and would impermissibly stand as an obstacle to the accomplishment

and execution of the full purpose and objectives of Congress in creating the

Exchange Act’s self-regulatory regime, including the portion of that regime

applicable to registered clearing agencies under Section 17A.

Finally, plaintiffs argue that there can be no conflict preemption in this case

because, in contrast to rules adopted by other SROs, the Commission does not

have the authority to abrogate or amend the rules of registered clearing agencies

once they have taken effect pursuant to Section 19(b). See Exchange Act Section

19(c), 15 U.S.C. 78s(c). They contend that therefore the Commission’s

“‘approval’ of the [stock borrow program] was not a true regulatory decision in

any meaningful respect” because the Commission lacks the authority “to alter the

-25-

program proposed by the defendants, and therefore cannot remedy the defects” in

the stock borrow program. Pltf. Br. at 30 (emphasis in the original).

It is important to appreciate the full consequences of this argument.

Because the Commission cannot abrogate or amend any clearing agency rule,

plaintiffs’ assertion, if correct, would mean that no clearing agency rule has any

preemptive effect, so that any state law in conflict with a clearing agency rule

would prevail over the rule. That result would obviously have far-reaching and

potentially seriously disruptive effects on the nation’s system of securities

clearance. It is therefore perhaps not surprising that plaintiffs cite no authority for

the proposition that a regulator’s authority to approve rules, but not to abrogate or

amend them, means that the rules do not have preemptive effect.

In any case, plaintiffs’ assertion that clearing agency rules cannot preempt

state law because the Commission cannot abrogate or amend them is erroneous for

at least two reasons. First, even prior to 1975, when Congress amended Section

19 of the Exchange Act to give the Commission authority to pass upon the validity

of all SRO rules, the Supreme Court had recognized that properly adopted SRO

rules could preempt conflicting state law, even though the rules had not been

reviewed by the Commission. See Ware, 414 U.S. at 127, 129-31. Given that

SRO rules adopted without Commission approval had preemptive effect prior to

-26-

1975, it is clear that Commission-approved rules have preemptive effect even

though the Commission does not have authority to abrogate or amend those rules.

More fundamentally, even though the Commission cannot abrogate or

amend clearing agency rules, Section 17A gives it plenary rulemaking authority of

its own that would permit it to remedy any defects in the stock borrow program, or

any other clearing agency operation within the Commission’s regulatory purview.

As explained above, Section 17A(d)(1) prohibits a registered clearing agency from

directly or indirectly engaging in “any activity as clearing agency * * * in

contravention of such rules and regulations as the Commission may prescribe as

necessary or appropriate in the public interest, for the protection of investors, or

otherwise in furtherance of the purposes of” the Exchange Act. Indeed, when the

Commission gave final approval to NSCC’s registration as a clearing agency, it

observed that in the future, “as necessary,” it would use “its rulemaking authority

under Section[]17A(d)(1) * * * to ensure continued development of the” national

clearance and settlement system. If the Commission were to conclude that the

stock borrow program is contrary to the public interest or the protection of

investors, it could adopt a corrective rule, with which NSCC would have to

comply, even though the rule would not be a rule of the clearing agency.

-27-

There are remedies for manipulations perpetrated by naked short

sellers.

It should be borne in mind that the fact that plaintiffs’ claims are preempted

does not mean that there are no remedies for manipulation by naked short sellers.

These remedies include law enforcement actions against the wrongdoers by the

government and private actions against the wrongdoers for damages. If the

alleged problem is systemic rather than arising from isolated unlawful conduct, the

appropriate remedy is to amend the regulatory regime. The Commission has not

been unaware of allegations similar to those made by plaintiffs. See Order

Granting Approval of a Proposed Rule Change Concerning Requests for

Withdrawal of Certificates by Issuers, SEC Rel. No. 34-47978, 68 Fed. Reg.

35037, 35042 (June 11, 2003), Short Sales, SEC Rel. No. 34-50103, 69 Fed. Reg.

48008, 48016 n.85 (Aug. 6, 2004); Issuer Restrictions or Prohibitions on

Ownership by Securities Intermediaries, 69 Fed. Reg. 70852, 70856 n.53 (Dec. 7,

2004).

Moreover, the Commission recently adopted Regulation SHO, which took

effect a little over a year ago, to address its concern that naked short selling could

cause an excessive number of extended fails-to-deliver. See Regulation SHO

Proposing Release, SEC Rel. No. 34-48709, 68 Fed. Reg. 62972, 62975-78 (Nov.

6, 2003) (discussing problems potentially caused by naked short selling); Short

-28-

Sales, 69 Fed. Reg. at 48009 (explaining that certain provisions of Regulation

SHO are designed to reduce short selling abuses); 48013 n.53 (noting that most

commenters welcomed the regulation as a means to address naked short selling

manipulation).

Among other requirements, Regulation SHO (1) requires broker-dealers to

locate securities that are available for borrowing prior to effecting a short sale in

any equity security, and (2) requires clearing agency participants to close out fail

to deliver positions by purchasing securities of like kind and quantity for securities

that are identified by a formula established by the regulation as having a

substantial amount of fails. Short Sales, 69 Fed. Reg. at 48014, 48016-17.

The Commission also stated that it “intend[ed] to pay close attention to the

operation and efficacy of the provisions we are adopting * * *, and will consider

whether any further action is warranted.” Short Sales, 69 Fed. Reg. at 48018; see

id. at 48017 (“if the Commission believes that the rules as adopted are not having

the intended effects of reducing potentially manipulative behavior, we may

consider additional rulemaking”). The Commission has every intention of

following through on that statement and taking any steps that it finds are necessary

or appropriate in the future.

-29-

CONCLUSION

For the foregoing reasons, the ruling of the district court should be affirmed.

Respectfully submitted,

__________________________

JACOB H. STILLMAN

Solicitor

__________________________

MARK PENNINGTON

Assistant General Counsel

__________________________

MICHAEL L. POST

Senior Counsel

(Pursuant to Nev. S. Ct. R. 43)

Securities and Exchange Commission

100 F St. NE

Washington, DC 20549-8010

(202) 551-5194 (Post)

February 2006

-30-

CERTIFICATE OF COUNSEL

I hereby certify that I have read this brief amicus curiae, and to the best of

my knowledge, information and belief, it is not frivolous or interposed for any

improper purpose. I further certify that this brief complies with all applicable

Nevada Rules of Appellate Procedure, in particular, Nev. R. App. P. 28(e), which

requires every assertion in the brief regarding matters in the record to be supported

by appropriate references to the record on appeal. I understand that I may be

subject to sanctions in the event that the accompanying brief is not in conformity

with the requirements of the Nevada Rules of Appellate Procedure.

______________________

Mark Pennington

Assistant General Counsel

CERTIFICATE OF SERVICE

I certify that the foregoing Motion was served on February 2, 2006, by

overnight delivery on the following:

David N. Frederick, Esq.

LIONEL SAWYER & COLLINS

50 West Liberty St., Suite 1100

Reno, NV 89501

Michael J. Morrison, Esq.

1495 Ridgeview Dr., Suite 220

Reno, NV 89509

William E. Cooper, Esq.

601 E. Bridger Ave.

Las Vegas, NV 89101

Bruce T. Laxalt, Esq.

LAXALT & NOMURA

9600 Gateway Drive

Reno, NV 89521

Gregg M. Mashberg, Esq.

PROSKAUER ROSE LLP

1585 Broadway

New York, NY 10036

______________________

Mark Pennington

CERTIFICATE OF FILING

I certify that I filed the foregoing Brief with the Nevada Supreme Court by

overnight delivery to the following:

Clerk of the Court

Supreme Court of Nevada

201 S. Carson St., Suite 201

Carson City, NV 89701-4702

______________________

Mark Pennington

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.