Financial Services Law

State and Federal Lawmakers, Chair of Fed Weigh in on Regulation of Virtual Currency

The New York Department of Financial Services issued an order on Wednesday that it will immediately start accepting applications and formal proposals for the establishment of virtual currency exchanges. NYDFS Superintendent Benjamin Lawsky said that recent problems at several Bitcoin exchange firms “further demonstrate the urgent need for stronger oversight of virtual currency exchanges, including robust standards for consumer protection, cyber security, and anti-money laundering compliance.” He also said that his department “will continue to proceed swiftly and thoughtfully to provide rules of the road for reputable virtual currency firms seeking to conduct business on-shore in a responsible manner.”

Lawsky gave notice that a regulatory framework would be proposed by the end of the second quarter of 2014 and approved exchanges would “ultimately” be expected to comply with such rules. The order states that “any appropriate framework should include strong legal and operational controls, including robust BSA/AML requirements.” The concept of a “BitLicense” still appears to be on the table as part of this initiative.

The Texas Banking Department also announced last week that it will be issuing regulations addressing virtual currencies in the next 60 days.

Virtual currency, and Bitcoin in particular, continue to attract attention in Washington, D.C., as well. Sen. Joe Manchin (D-W.Va), a key member of the Senate Banking Committee, has proposed the United States issue a ban on Bitcoin in a letter to federal financial regulators. “This virtual currency is currently unregulated and has allowed users to participate in illicit activity, while also being highly unstable and disruptive to our economy,” he wrote to Chair of the Federal Reserve Board Janet Yellen and Treasury Secretary Jack Lew, among others.

One lawmaker responded to Sen. Manchin’s with his own letter to regulators, tongue firmly in cheek. Rep. Jared Pollis (D-Colo.) suggested that banning cash would be just as effective as banning Bitcoins, writing that “[d]ollar bills are present in nearly all major drug busts in the United States and many abroad.” Cash allows for anonymous transactions perfect for illegal activity “from drug purchases, to hit men, to prostitutes,” Rep. Pollis wrote, noting that digital currencies are also carbon neutral and more environmentally friendly than cash.

Testifying at a hearing of the Senate Banking Committee, Chair of the Federal Reserve Board Janet Yellen said her agency has no plans – and no jurisdiction – to issue regulations.

Yellen told lawmakers that Bitcoin and other digital “payment innovations” are outside the Board’s purview. “To the best of my knowledge, there is no intersection in any way between Bitcoin and banks that the Fed has the ability to supervise and regulate.” Responding to a question from Sen. Manchin (D-W.Va.), Yellen said, “the Fed does not have authority with respect to Bitcoin.”

Instead, Yellen said virtual currency would fall under the purview of the Justice Department and/or the Financial Crimes Enforcement Network within the Treasury Department. “They have indicated that their money laundering statutes are adequate to meet their own enforcement needs,” she said.

The Chairwoman proposed another possible regulator: Congress. “It certainly would be appropriate, I think, for Congress to ask questions about what the right legal structure would be for virtual currencies that involve nontraditional players,” she told the Committee.

The recent failure of several Bitcoin exchanges generated statements from other legislators. Some – like Sen. Tom Carper (D-Del.) – called for regulation as an attempt to protect consumers. “U.S. policymakers and regulators can and should learn from this incident,” he said in a statement. “As any industry matures it will face growing pains.”

To read Sen. Manchin’s letter, click here.

To read Rep. Pollis’ letter, click here.

Why it matters: A road map for regulation of virtual currency is beginning to emerge as more states appear willing to consider issuing licenses for entities offering exchange and other services involving virtual currency. While immediate action at the federal level seems unlikely, several states are expected to be acting on new regulations soon. Most importantly, Bitcoin and virtual currencies businesses can start the process of getting a license to serve customers in one of the most desirable markets in the US. (Click here to read our previous newsletter.) Whether or not federal lawmakers will take action remains to be seen.

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Supreme Court Allows State Court Actions Under SLUSA

The Securities Litigation Uniform Standards Act of 1998 does not preclude state law actions seeking to recover investments lost in Ponzi schemes, the U.S. Supreme Court held in a seven to two decision last week.

R. Allen Stanford and his Stanford Group Co. sold certificates of deposit in its Stanford International Bank promising a fixed rate of return. The plaintiffs claimed they expected the bank would use the money to buy highly lucrative assets; instead, Stanford and his associates spent the money to finance an elaborate lifestyle and repay old investors.

When the scam was uncovered, Stanford was convicted of mail fraud and wire fraud, among other federal charges; he was sentenced to prison and required to forfeit $6 billion. In addition, the Securities and Exchange Commission brought a civil suit against Stanford in which the court imposed a civil penalty of $6 billion.

Further, four civil class action suits were filed by private investors against investment advisors affiliated with Stanford, and others including law firms and insurance brokers, alleging that these groups helped Stanford and the Bank perpetrate the fraud, thereby violating Texas state law. A federal court overseeing the consolidated suits granted the defendants’ motion to dismiss, ruling the cases were precluded by the SLUSA. The Fifth U.S. Circuit Court of Appeals reversed and the Supreme Court granted certiorari.

In an opinion delivered by Justice Stephen Breyer, the Court affirmed that the class action plaintiffs could bring suit.

The majority focused on Section 78bb(f)(1) of the SLUSA, which forbids the bringing of large securities class actions by a private party based upon violations of state law where the plaintiffs allege “a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.”

This provision simply did not apply to the litigation at hand, Justice Breyer wrote, because the plaintiffs claimed they purchased uncovered securities and the scope of the statutory language should not extend further – despite the fact that the defendants falsely told the victims that the uncovered securities were backed by covered securities.

The Court reached this conclusion for several reasons. First, the Act itself focuses upon transactions in covered securities (i.e., securities traded on a national exchange or those issued by investment companies), not upon transactions in uncovered securities. Second, the statutory language suggests a “connection that matters,” meaning that the alleged misrepresentation “makes a significant difference to someone’s decision to purchase or to sell a covered security, not to purchase or to sell an uncovered security, something about which [the SLUSA] expresses no concern.” Third, every prior securities case in which the Court found a fraud to be “in connection with” a purchase or sale of a security involved “[victims’] ownership interest in financial instruments that fall within the relevant statutory definition,” in contrast to this case, in which ownership was of securities outside the scope of the SLUSA. Fourth, the SLUSA must be read in conjunction with underlying regulatory statutes like the Securities Exchange Act of 1934 and the Securities Act of 1933, the purpose of which, again, “suggests a statutory focus upon transactions involving the statutorily relevant securities.” Finally, a broader interpretation of Section 78bb(f)(1) would interfere with state efforts to provide remedies for fraud victims, an intent at odds with the numerous provisions included in the SLUSA that purposefully maintain state authority.

As to the dissent’s contention that the opinion could significantly curtail the SEC’s enforcement powers, the majority held the case itself belied that argument. “That would be news to Allen Stanford, who was sentenced to 110 years in federal prison after a successful federal prosecution, and to Stanford International Bank, which was ordered to pay billions in federal fines, after the same,” Justice Breyer wrote. “Frauds like the one here – including this fraud itself – will continue to be within the reach of federal regulation because the authority of the SEC and Department of Justice extends to all ‘securities,’ not just to those traded on national exchanges.”

Justice Clarence Thomas filed a concurring opinion, while Justice Samuel Alito joined Justice Anthony Kennedy’s dissent.

Advocating for a broader reading of Section 78bb(f)(1), Justice Kennedy cautioned that the majority’s opinion would have a negative impact on the national securities markets, inhibit the SEC from policing fraud, and “subject many persons and entities whose profession it is to give advice, counsel, and assistance in investing in the securities markets to complex and costly state-law litigation based on allegations of aiding or participating in transactions that are in fact regulated by the federal securities laws.”

To read the Supreme Court’s opinion in Chadbourne and Parke v. Troice, click here.

Why it matters: The decision provides some clarity as to the meaning of the “in connection with” language of the SLUSA. In addition, while the decision is a victory for plaintiffs seeking to file state law fraud claims, the impact is limited to transactions that do not involve securities traded on a national exchange; SLUSA preclusion still applies to state law claims against third parties involving covered securities. Only time will tell whether the decision will lead to the proliferation of state-law class actions, as suggested by Justice Kennedy.

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CFPB: Credit Card Companies Should Provide Consumers With Free Credit Scores

The top complaint from consumers about credit cards? According to a new report from the Consumer Financial Protection Bureau, consumers were most frustrated with “accuracy issues.”

To improve the situation, the Bureau suggested that credit card companies make credit scores and other consumer content freely available to consumers, as is already being done by some card companies.

About 31,000 of the 289,000 consumer complaints received by the CFPB between July 21, 2011 and February 1, 2014, or 11 percent, focused on credit reporting. Of the credit-focused complaints, 73 percent of consumers reported that incorrect information had appeared on their credit reports. One consumer found a mortgage listed on his report that would have been taken out while he was a sophomore in high school.

Other common types of complaints included frustration with credit reporting companies’ investigations of disputed information (11 percent expressed unhappiness with issues like depth and validity of the investigations) while 9 percent of the complaints were based on an inability to get a credit report or credit score.

The CFPB’s proposed solution: “[m]aking consumers’ credit scores freely available on their monthly statement or online makes it easier for them to spot problems with their credit report,” Bureau director Richard Cordray said in a statement, noting that less than one in five Americans check their credit report in any given year.

To encourage credit card companies to provide the information to consumers, Cordray sent letters to several companies “strongly encouraging” them “to make the credit scores on which you rely available to your customers regularly and freely, along with educational content to help them make use of this information.”

Cordray noted that some issuers have already introduced programs that provide such information to consumers. “We will consider this to be a ‘best practice’ in the industry,” he wrote.

In addition to Cordray’s friendly request, the Bureau also published a supervisory bulletin reminding companies that provide data to credit reporting agencies of their duty to investigate consumer disputes. “The Bureau has observed that data furnishers sometimes respond to a dispute by simply deleting the disputed accounts from the information they pass along to the credit reporting company,” the agency said, calling the practice “detrimental” to consumers as it could lead to an inaccurate credit report.

The Bureau warned data furnishers – any entity that provides consumer information to a credit reporting agency for inclusion in a consumer report – that it will continue to monitor their compliance with the investigation requirements and take supervisory or enforcement action where necessary.

To read the CFPB’s “Credit reporting complaint snapshot,” click here.

To read Cordray’s letter, click here.

To read the CFPB’s bulletin on the duty to investigate disputed information, click here.

Why it matters: In his letter to credit card companies, Cordray contended that customers “who monitor and manage their credit standing may be less likely to become delinquent or to default,” and that while consumers who are aware of their credit information are more capable of protecting themselves and to benefit from the opportunities credit can create, ultimately making them more productive members of the economy. He also noted that credit reports are a “major focus” for the Bureau, putting companies on notice of continued oversight by the agency. Any action that the CFPB “strongly encourages” entities subject to CFPB enforcement to take obviously should be carefully considered.

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