Sunday, February 11, 2018

Recent CFTC enforcement actions related to digital assets

The recent CFTC enforcement actions have highlighted the fact that the US regulators are paying increased attention to the conduct of ICOs and the trading of digital assets.

All three cases involve fraud.  The January 16, 2018 enforcement action charged My Big Coin Pay, Inc. and its principals with fraud and misappropriation of  over $6 million from customers by transferring customer funds into personal bank accounts and using those funds for personal expenses and the purchase of luxury goods.  The action states that for four years the defendants misrepresented to customers that their virtual currency known as My Big Coin ("MBC") was actively traded on several currency exchanges, which in fact it was not; that MBC was backed by gold, which was not true; and that MBC partnered with MasterCard with the promise that MBC could be used anywhere MasterCard was accepted, which was also not true.  (The CFTC release is found here).

The CFTC filed its second civil enforcement action on January 18, 2018 against Dillon Michael Dean of Colorado and his company The Entrepreneurs Headquarter Limited, a UK-registered company.  The CFTC complaint charges the defendants with soliciting Bitcoins from the public, misrepresenting that a portion of the funds would be used to invest into products such as binary options, making Ponzi-style payments to the participants from other participants' funds, and failing to register as a commodity pool operator with the CFTC.

Also, on the same day, the CFTC charged Patrick McDonnell and his company CabbageTech, Corp. d/b/a Coin Drop Markets with fraud and misappropriation in connection with purchases and trading of Bitcoin and Litecoin.  The defendants solicited customers to send them money or virtual currencies in exchange for virtual currency trading advice that was never delivered.

The first question that comes to mind is why is it the CFTC that is filing these enforcement actions, and not the SEC?  After all, we have all been preoccupied with the question of whether digital tokens are securities under the US securities laws, and the regulation of securities offerings is the realm of the SEC.  The second question is whether investment managers of crypto funds (investment funds that pool money to invest into digital assets) have to register with the CFTC as commodity pool operators (CPOs).

According to the recent SEC pronouncements, more and more tokens are going to be deemed to be securities rather than utility tokens or currencies, especially while the platform on which they would function has not yet been built.  Those other tokens that are not securities may be utility tokens or currencies, which makes them "commodities" falling under the regulation by the CFTC. 

In its 2015 Order in to the Matter of CoinFlip, Inc., the CFTC said:

"Section 1a(9) of the Act defines "commodity" to include, among other things, "all services, rights, and interests in which contracts for future delivery are  presently or in the future dealt in." 7 U.S.C. § 1a(9). The definition of a  "commodity" is broad. See, e.g., Board ofTrade ofCity ofChicago v. SEC, 677  F.  2d 1137, 1142 (7th Cir. 1982). Bitcoin and other virtual currencies are  encompassed in the definition and properly defined as commodities."

Since commodity-based derivative contracts are within the CFTC regulation, including registration, reporting and other requirements, the CFTC charged CoinFlip with unlawfully offering commodity options without being properly registered with the CFTC.

In October 2017, the LabCFTC issued a Primer on Virtual Currencies, in which it considered possible cases where the virtual currency is deemed to be a commodity.  The report confirmed that Bitcoin and other virtual currencies are commodities.  The CFTC has oversight of derivatives, futures and options contracts and that "the CFTC's jurisdiction is implicated when a virtual currency is used in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce."   The report also stated that there is no inconsistency between the regulation by the SEC and the CFTC because "virtual tokens may be commodities or derivatives contracts depending on the particular facts and circumstances."

Therefore, regulation and enforcement actions by both the SEC and the CFTC are appropriate in connection with fraudulent practices on the ICO market.  It has been argued with respect to the overlapping of the CFTC and the SEC jurisdictions, that the CFTC may be better positioned to deal with fraud in virtual currency markets because its Rule 180.1 (the equivalent of the SEC Rule 10b-5) has a broader reach.  It extends to any "manipulative device, scheme, or artifice to defraud" that has a relationship to a commodity in interstate commerce, whereas Rule 10b-5 applies only to the actual transaction involving the purchase or sale of a security.

Now, let's consider our second question.  The CFTC defines a commodity pool as "an investment trust, syndicate, or similar form of enterprise operated for the purpose of trading commodity futures or option contracts. Typically thought of as an enterprise engaged in the business of investing the collective or “pooled” funds of multiple participants in trading commodity futures or options, where participants share in profits and losses on a pro rata basis."  Accordingly, those crypto funds that invest their funds into derivative contracts based on virtual currencies may well be deemed to be commodity pools, and therefore, their managers would need to register with the CFTC as commodity pool operators.

One of the charges brought by the CFTC in the January 18th enforcement action against Dean and The Entrepreneurs Headquarters Limited was Dean's failure to register as a CPO.

In conclusion, it is likely that we will see more CFTC actions against participants in the virtual currency marketplace, as well as joint SEC and CFTC enforcement efforts. 

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

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