Securities Snapshot
January 16, 2018

Regulators Step Up Scrutiny on Securities Related to Cryptocurrencies and ICOs

The SEC temporarily suspends trading in the trading of a Hong Kong-based blockchain business, while the NASAA issues warning regarding cryptocurrency investments; the Supreme Court grants certiorari to resolve whether the hiring of SEC administrative law judges violates the Appointments Clause; two federal courts of appeals affirm the dismissal of putative state law class actions under the Securities Litigation Uniform Standards Act; Alabama federal court finds PricewaterhouseCoopers negligent in failing to detect fraud in the financial statements of failed Alabama bank; Texas federal court allows securities fraud suit against a Santander unit and several executives to proceed; and New York appeals court reverses dismissal of a malpractice claim by investment bank against outside underwriter’s counsel.

On January 5, 2018, the U.S. Securities and Exchange Commission announced the temporary suspension, pursuant to Section 12(k) of the Securities Exchange Act of 1934, of trading in the securities of UBI Blockchain Internet, Ltd. (“UBIA”), terminating on January 22, 2018. The SEC temporarily suspended trading in the securities of UBIA because of “(i) questions regarding the accuracy of assertions, since at least September 2017, by UBIA in filings with the Commission regarding the company’s business operations; and (ii) concerns about recent, unusual and unexplained market activity in the company’s Class A common stock since at least November 2017.” The trading halt comes as regulators step up scrutiny of securities related to cryptocurrencies in general, including tougher enforcement over initial coin offerings. An organization representing state securities regulators, the North American Securities Administrators Association (“NASAA”) issued an alert reminding individual and small-business investors to be cautious about investments involving cryptocurrencies. The alert warns investors on many fronts, including reliance on headlines or hype as the basis of investments, the high risk and volatility associated with these products, minimal regulatory oversight of cryptocurrencies, cybersecurity risks (i.e., breaches or hacks), and potential lack of recourse if the cryptocurrency disappears. The alert also identifies various red flags NASAA thinks investors should have on their radars, including guaranteed high investment returns, unsolicited offers, offers that sound too good to be true, pressure to buy immediately, and unlicensed sellers. Following the NASAA alert, the SEC Chairman and Commissioners issued a statement commending NASAA for its action and highlighting the related investor bulletins, alerts, reports, and statements the SEC has issued on the topic of cryptocurrencies. The SEC also reiterated that it and state regulators are pursuing more enforcement actions against cryptocurrency-related investment products and ICOs that run afoul of laws.

Supreme Court Grants Certiorari in Appeal Challenging Hiring of SEC Administrative Law Judges

On January 12, 2018, the Supreme Court granted certiorari in Raymond James Lucia Cos. Inc. v. SEC, to resolve a split between the D.C. and Tenth Circuits over whether the hiring of SEC administrative law judges violates the Appointments Clause of the Constitution. At issue is whether SEC ALJs are Officers subject to the Constitution’s Appointments Clause, or whether they are merely employees, who do not require appointment by the President or a Presidential appointee. The SEC currently selects ALJs through an internal administrative process, pursuant to 5 U.S.C § 3105. One such ALJ had sanctioned Mr. Lucia, an investment advisor, to a lifetime ban and a $300,000 fine for misleading investors over a retirement strategy he created. He appealed first to the SEC’s commissioners, then to the D.C. Circuit, both of which rejected his argument that ALJs are inferior officers of the United States who must be appointed by the President, the head of an agency, or a court of law. In denying his petition for review, a three-judge panel of the D.C. Circuit found that the ALJs act as employees who do not issue final decisions, rather than officers who, as Mr. Lucia argued, carry out judicial proceedings, including evidentiary procedures and handing down decisions, and whose decisions the SEC rarely overturns or gives more than a cursory review. The D.C. Circuit’s ruling conflicts with a December 2016 ruling by the Tenth Circuit in Bandimere v. SEC and its May 2017 denial of a request for rehearing en banc, which held that ALJs are inferior officers of the United States subject to the Appointments Clause. The SEC itself supported certiorari in the Lucia case, with the Solicitor General stating in a November 2017 brief that the SEC now considers the ALJs to be officers of the United States subject to the Appointments Clause. A ruling by the Supreme Court that SEC ALJs have been appointed unconstitutionally would call into question all prior SEC ALJ adjudications. The Court is expected to hear the case during the April sitting and to issue a decision this term.

Eighth and Ninth Circuits Affirm Dismissal of Customer Class Actions for Lack of Jurisdiction Under SLUSA

On December 29, 2017, the Ninth Circuit affirmed the dismissal of Lim v. Charles Schwab & Co., Inc. and Fleming v. The Charles Schwab Corp., et al., two putative class action complaints bringing state law claims by customers of Charles Schwab Corp. and Charles Schwab & Co., Inc., holding that the Securities Litigation Uniform Standards Act deprived the district court of subject matter jurisdiction over such claims. Plaintiffs Louis Lim and Charles Fleming each sued Schwab in the Northern District of California in 2005 for routing 95% of its non-directed trades to UBS Securities LLC by agreement, rather than seeking potentially more favorable order executions through other brokers. The complaints brought state law claims only, with Lim asserting violation of the California Unfair Competition Law, breach of fiduciary duty, and unjust enrichment, and Fleming claiming UCL violations, breach of contract, intentional misrepresentation, and negligent misrepresentation. Though affirming the lower court’s finding that the plaintiffs each had Article III standing, holding that they sufficiently alleged particularized and concrete injuries in the form of higher execution prices, the Ninth Circuit also affirmed the district court’s finding that the complaints were both barred by SLUSA, which prohibits state law class actions alleging deceptive practices connected to securities trading as a method of avoiding the Private Securities Litigation Reform Act’s heightened pleading standards. Because “the substance of all their allegations is that Schwab, motivated by a conflict of interest, deceived Plaintiffs into believing it would deliver best execution of their trades but knew that sending all trades to UBS would breach that duty,” the Ninth Circuit held that SLUSA requires dismissal. The Ninth Circuit reached the same conclusion as to the claims against UBS, which was named in the Fleming complaint only. In so doing, the Ninth Circuit resolved the disputed issue of whether Schwab made “a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security,” noting that the Supreme Court reads that requirement broadly to simply mean that it “coincide with a securities transaction,” and ruling that a breach of the duty of best execution may fall within the federal securities laws if it is based on fraud or nondisclosure, following earlier decisions by the Second, Third, Seventh, and Tenth Circuits.

Similarly, on January 9, 2018, the Eighth Circuit affirmed the dismissal of Lewis v. Scottrade, Inc., a customer class action against Scottrade alleging claims under Missouri law for the routing of customer orders to trading venues that provide rebates to the brokers who send them.  The Eighth Circuit held that the complaint, which brought claims under the Missouri Merchandising Practices Act, for breach of common law fiduciary duty, and for unjust enrichment, fell within the SLUSA bar and thus required dismissal, as its state law claims, “fairly read, allege material misrepresentations or omissions, or the use of a manipulative or deceptive device or contrivance, in connection with the purchase and sale of covered securities.”   

Alabama District Court Finds PwC Negligent in Colonial Bank Failure

On December 28, 2017, in The Colonial BancGroup, Inc. v. PricewaterhouseCoopers LLP, the U.S. District Court for the Middle District of Alabama found PricewaterhouseCoopers LLP negligent in connection in its review of Colonial BancGroup, Inc.’s financial statements. Following a bench trial, Judge Barbara Jacobs Rothstein of the Middle District of Alabama ruled that PwC violated auditing rules and did not take steps that could have detected a $2 billion fraud scheme that contributed to the 2009 failure of Alabama’s Colonial Bank. The ruling came in a lawsuit brought against PwC by the Federal Deposit Insurance Corp., in its capacity as receiver for Colonial Bank), and concerns a mortgage fraud scheme allegedly perpetrated by Taylor Bean & Whitaker Mortgage Corp., once one of the nation’s biggest mortgage companies.  The FDIC alleged that Taylor Bean said it would pay Colonial for the loans but instead pledged or sold them to third parties. After the alleged fraud was discovered, Taylor Bean filed for bankruptcy in August 2009, and Colonial failed soon after, costing the FDIC’s deposit insurance fund billions of dollars. PwC was the outside auditor for Colonial’s bank holding company, and gave Colonial clean audits that blessed its financial statements for years. The FDIC and the Colonial trustee had alleged PwC was negligent in not detecting the fraud scheme, and they sued the firm in 2012 and 2011, respectively. Judge Rothstein agreed, holding that PwC failed to design its audits to detect fraud, violating auditing standards. The court also held PwC could have uncovered the fraud simply by inspecting some of the underlying documents for the mortgages at issue, but it did not. The court will now consider separately whether damages should be imposed on PwC, and how much.  

Northern District of Texas Rejects Santander Effort to Dismiss Securities Fraud Class Action

On January 3, 2018, the Northern District of Texas denied a motion to dismiss as to all but one defendant in Parmelee v. Santander Consumer USA Holdings, Inc. et al., holding that the plaintiff’s amended complaint had largely satisfied the heightened standard for pleaded scienter and loss causation under the Private Securities Litigation Reform Act of 1995. Plaintiff Cynthia Parmelee brought suit on behalf of a putative class of individuals and entities who purchased securities in Santander Consumer USA Holdings, Inc., a consumer finance company that provides vehicle finance and unsecured consumer lending, between February 3, 2015 and March 15, 2016. Her complaint alleges that Santander violated Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, promulgated thereunder, by overstating income in SEC filings for the period of fiscal year 2011 to 2015, which Santander subsequently restated twice in a six-month period during 2016, after changing its methodology for estimating credit loss allowance. The plaintiff also brought claims against four Santander executives under Section 20(a) of the Exchange Act. The plaintiff alleged that former Chairman and CEO Thomas G. Dundon and two fellow executives sold stock at the artificially inflated price, with Dundon resigning and selling his stake in the company near the peak of the allegedly inflated stock price. In largely denying the motion to dismiss, Judge Ed Kinkeade held that the allegations of (1) numerous violations of basic GAAP principles, (2) repeated, significant restatements of the financials that resulted therefrom; and (3) trading by the three executives created “a strong inference of scienter and meet the heightened pleading standards as to those Defendants.” The court further held that the plaintiff had sufficiently pleaded a causal connection between Santander’s repeated corrective disclosures that corrected its earlier misrepresentations and the drop in the value of the company’s stock. Because it found the securities fraud claims to be adequately pleaded, it denied the motion to dismiss the Section 20(a) claims against Dundon and two of the other individual defendants. However, the court granted the motion to dismiss as to the fourth individual defendant, current CFO Ismail Dawood, as the amended complaint did not allege that he owned or sold Santander stock during the relevant period, and accordingly he did not possess the requisite scienter for either 10(b) or 20(a) claims.

Investment Bank's IPO Malpractice Suit Against Law Firm Reinstated

On January 9, 2018, a panel of the New York appeals court reversed a 2016 trial court dismissal of a malpractice suit brought by investment bank Macquarie Capital USA against its outside underwriter’s counsel. The malpractice suit involved an alleged failure by underwriter’s counsel to raise a red flag during transaction due diligence about misrepresentations made in Puda Coal’s 2010 initial public offering documents. Puda’s public filings stating it owned a 90 percent share in a Chinese entity, Shanxi Puda Coal Group Co. In the course of the underwriter process, Macquarie hired Kroll Inc., which issued a report stating that Puda’s ownership in the China affiliate had in fact been transferred to the company’s board chairman. Kroll shared the report with a Macquarie associate, who then passed it along to the Macquarie deal team and to outside underwriting counsel, with a cover email saying that “no red flags were identified.” The firm then issued a letter saying that nothing had been discovered to make it believe Puda had made any misrepresentations. The trial court dismissed the complaint on proximate cause grounds, noting that Macquarie had the report and could have relied on it to withdraw from the Puda deal. The appeals court reversed, stating that the Kroll report showing misrepresentations by Puda that both the law firm and Macquarie had “cannot [at the motion to dismiss stage] be described as explicitly putting plaintiff on notice and not requiring counsel’s interpretation of the information.” The court also found that it could reasonably be inferred from “plaintiff's allegations that it incurred damages attributable to defendant’s conduct, including litigation expenses incurred in an effort to avoid, minimize, or reduce the damages caused by defendant’s alleged negligence.”