Bridging the Week by Gary DeWaal: January 16 to 19 and 22, 2018 (Not Feeling Groovy; Registered Investment Funds and Cryptocurrencies; Bitcoin Investment Schemes; Reg SHO)

Jump to: Bitcoin Ecosystem    Bridging the Week    Canadian Regulation (sans Capital and Liquidity)    Compliance Weeds    Cryptosecurities    Customer Protection    Fraud and Anti-Fraud    Legal Weeds    Managed Money    Manipulation    My View    Reg SHO   
Email Print
Published Date: January 21, 2018

The Securities and Exchange Commission’s Division of Investment Management warned sponsors of registered investment funds not to seek approval to trade cryptocurrencies because of many concerns regarding the asset class. Separately, the Commodity Futures Trading Commission publicized two enforcement actions involving alleged fraud in connection with cryptocurrency investment schemes. Various media outlets report that a third action has been filed too, but it has not yet been publicized by the Commission. As a result, the following matters are covered in this week’s edition of Bridging the Week:

Video Version:

Article Version:


Moreover, the Division said that if an existing fund able to use a post-effective amendment to substantially invest in cryptocurrencies did so, it would view such act “unfavorably” and might recommend a stop order to the Commission.

The two industry organizations receiving the Division’s letter are the Investment Company Institute and the Securities Industry and Financial Markets Association’s Asset Management Group.

Although the Division noted that “[f]lexibility to innovate” is an important feature of the law governing investment funds and that advocates of cryptocurrencies have suggested numerous potential benefits associated with the product, critics “have raised various concerns regarding transparency of information, trading, valuation and other matters…”

As a result, the Division sought input regarding a number of relevant matters. These include how funds would value cryptocurrencies; choose newly created cryptocurrencies to invest and deal with forks of existing digital products; take steps to assure that they had adequate liquidity to meet redemptions; and comply with custody requirements. The Division also inquired how concerns expressed by some, including SEC Chairman Jay Clayton, regarding the potential for manipulation and other risks associated with cryptocurrencies impacted fund sponsors’ views regarding valuation and liquidity.

The Division implied that, until its questions were answered “satisfactorily,” it was not likely to consider for approval any registered fund to invest in cryptocurrencies. The Division provided no deadline for the two industry groups or others to respond to its questions.

Separately, in unrelated developments regarding cryptocurrencies:

My View: Although the process by which the SEC is seeking industry comment on an important topic appears a bit unusual, and at least some  fund sponsors are likely very disappointed by staff’s delay in approving and even threatening to disapprove registered funds to trade cryptocurrencies until further notice, it is at least a positive development that staff has articulated its specific concerns and is soliciting dialogue.

Previously, in its denial of a proposed BZX rule change to accommodate trading of shares in the Winklevoss Bitcoin Trust, the SEC indicated that its principal concern was the lack of a federally regulated market that traded Bitcoin or Bitcoin futures (click here to access the relevant SEC Order). Since that time, trading in cash-settled Bitcoin futures overseen by the CFTC has commenced on the Chicago Mercantile Exchange and the CBOE Futures Exchange, and trading in swap contracts potentially settling in Bitcoin was approved by the CFTC for LedgerX and has been underway for a few months. Clearly, based on the plain language of the prior SEC Order, this should have been enough to give comfort to the SEC to approve investment funds to trade derivatives on CFTC-overseen cryptocurrency markets.

But apparently, this has not been the case as other concerns remain.

Hopefully, responses received by the Division to its solicitation for comment will empower the SEC to promptly authorize investment funds to trade at least some types of cryptocurrencies subject to disclosures and other reasonable and appropriate conditions it may determine, even if the Commission generally remains uncomfortable with the asset class. As CFTC Chairman J. Christopher Giancarlo said last week before lawyers at the ABA Derivatives and Futures Section conference, “I am disinclined to set regulatory policy from personal value judgments as to the social utility of a lawful, emerging technology, however considerable the inherent risks.” (Click here to access Mr. Giancarlo’s full comments regarding the federal oversight of cryptocurrencies.)

In one action that named CabbageTech, Corp., a NY corporation, and Patrick McDonnell, its owner and controller, the CFTC charged the defendants with unlawfully soliciting customers to send money and virtual currencies for virtual currency trading advice and for the discretionary trading of virtual currencies by Mr. McDonnell. However, alleged the CFTC, the defendants did not provide the promised services and misappropriated their customers’ funds.

The CFTC charged CabbageTech—which conducted business as Coin Drop Markets—and Mr. McDonnell with fraud.

In the other action, the CFTC named as defendants The Entrepreneurs Headquarters Limited (EHL)—a company incorporated in England and Wales—and Dillon Dean, its sole founder, principal, director and officer. The CFTC charged that the defendants solicited Bitcoin from customers in order to pool their funds and invest in financial products, including binary options traded on the Nadex, a CFTC-registered binary options exchange. In reality, claimed the CFTC, the defendants misappropriated customers’ funds, including using assets from some customers to pay other customers in a Ponzi scheme.

The CFTC alleged that EHL and Mr. Dillon also engaged in fraud, and acted in capacities requiring registration under law (i.e., as a commodity pool operator and an associated person, respectively) without being registered.

The CFTC seeks a permanent injunction against all the defendants in both actions, disgorgement and fines, among other penalties.

The media reported that the CFTC also filed a third enforcement action last week in connection with an alleged cryptocurrency investment scheme (click here for a sample article). However, no details were available as of January 12, 2018.

Following publication of the two CFTC enforcement actions, the heads of enforcement of both the SEC (Stephanie Avakian and Steven Peikin) and CFTC (James McDonald) issued a joint statement noting that their agencies would continue to address violations of law and stop fraud in connection with the offer and sale of digital instruments (click here to read the joint statement).

Legal Weeds: The CFTC’s enforcement action against CabbageTech and Mr. McDonnell marked the second time the Commission has brought an enforcement action against defendants that charged fraud in connection with purported offers or sales of spot cryptocurrencies and not futures or swaps based on cryptocurrencies. Last September, the CFTC sued Gelfman Blueprint, Inc. and Nicholas Gelfman, its chief executive officer and head trader, with running a Ponzi scheme related to Bitcoin. The CFTC brought both its most recent and other enforcement action under a relatively new provision of law (enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act) and Commission regulation that prohibits any person from using a manipulative or deceptive device or contrivance in connection with any “contract for sale of any commodity in interstate commerce”—not solely in connection with swaps or a commodity for future delivery on or subject to the rules of any registered entity. (Click here to access CEA Section 6(c)(1), 7 U.S.C. §9(1) and here for CFTC Rule 180.1(a).)

As I wrote at the time the Gelfman Blueprint case was announced, “[t]he CFTC's willingness to use these provisions in response to a fact pattern related to a commodity only – Bitcoin –, and not to futures or swaps based on Bitcoin, is a powerful statement about its view of its own role in the cryptocurrency arena going forward.” (Click here for further details regarding the Gelfman Blueprint enforcement action in the article, “CFTC Files Charges Alleging Bitcoin Ponzi Scheme Not Involving Derivatives.”)

Compliance Weeds: Under Reg SHO (click here to access this regulation at 15 USC § 240.15c3-5), a broker-dealer accepting a short sale of an equity security from a customer (or engaging in a short sale in its own proprietary account) must first borrow the security, enter into a bona fide arrangement to borrow the security, or have reasonable grounds to believe the security can be borrowed before the delivery date. Broker-dealers comply with this so-called “locate requirement” by maintaining so-called “easy to borrow” lists, which set forth equity securities they reasonably believe they can borrow. Absent an authorized basis, brokers that are participants on a registered clearing agency must close out failure to delivery transactions by no later than the beginning of trading on the settlement day following settlement day of the relevant securities (T+4). However, if the participant can demonstrate that a fail occurred from a long sale or is attributable to bona fide market maker activities, it must close out the relevant securities by no later than the beginning of trading on the third consecutive settlement following the settlement date (T+6). Many other very technical requirements may apply. (Click here for background regarding Reg SHO in an SEC publication, Key Points About Regulation SHO.)

More Briefly:

For further information:

Broker-Dealer Agrees to Pay US $1.25 Million to SEC to Resolve SEC Alleged Reg SHO Violations:

Canadian Self-Regulator Recommends Areas of Attention for Dealer Members:

CBOE Futures Exchange Proposes Change to Trading Halt Rule for Bitcoin Futures:

CFTC Files Two Enforcement Actions Charging Fraud in Connection with Cryptocurrencies Sale Schemes:

Federal Court Denies a Defendant’s Motion to Disqualify All SEC Trial Counsel in Manipulation Enforcement Action Because of Inadvertent:

FINRA Fines Another Broker-Dealer For Alleged Breakdowns in Custody and Control of Customer Fully-Paid and Excess Margin Securities:

SEC Not Feeling Groovy About Cryptocurrencies – Tells Registered Investment Funds: Slow Down, You Move Too Fast:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of January 20, 2018. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.

Recent Commentaries




Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.

Social Media:


Katten is a firm of first choice for clients seeking sophisticated, high-value legal services in the United States and abroad.

Our nationally recognized practices include corporate, financial services, litigation, real estate, environmental, commercial finance, insolvency and restructuring, intellectual property, and trusts and estates.

Our approximately 650 attorneys serve public and private companies, including nearly half of the Fortune 100, as well as a number of government and nonprofit organizations and individuals.

We provide full-service legal advice from locations across the United States and in London and Shanghai.


Gary DeWaal
Katten Muchin Rosenman LLP
575 Madison Avenue
New York, NY 10022-2585


Request Information »

Join Mailing List »