A social media company and its wholly owned subsidiary sued by the Securities and Exchange Commission for conducting an offering of an unregistered digital security claimed that the agency was wrong in its characterization of the cryptoasset. The virtual asset was not a security but a virtual currency, claimed the companies. Moreover, the defendants argued that the SEC has never definitively described when a cryptoasset might morph from being a security to a virtual currency, and was impermissibly enacting new regulations through enforcement. Separately, a proprietary trading firm agreed to settle enforcement actions by the Commodity Futures Trading Commission and the Department of Justice by paying a US $67.4 million sanction. As a result, the following matters are covered in this week’s edition of Bridging the Week:
In its complaint, the SEC charged that, in the first quarter of 2018, the defendants raised US $1.7 billion, including $424.5 million from US persons to fund the development of a proprietary blockchain – the Telegram Open Network – as well as their mobile messaging application, Telegram Messenger. The SEC claimed that the defendants’ offer and sale of Grams to US persons constituted an unregistered securities offering, and that Grams are securities because initial purchasers and subsequent investors expected to profit through Telegram’s efforts to develop TON, including to attract sellers and developers to use the blockchain, and to promote Grams. Among other things, said the SEC, Telegram proposed to facilitate resales on digital-asset trading platforms.
In their answer, defendants said that their fundraise from US persons was conducted pursuant to a valid exemption from securities registration laws – Regulation D. (Click here for background on Reg D.) They argued that what investors purchased in 2018 were investment contracts for a cryptocurrency. However, because the blockchain on which the cryptocurrency would operate was to have been completed and operational by the time the cryptocurrency was scheduled to have been issued by October 31, 2019, the virtual asset would not be a security when issued. Thus, any resale restrictions that would ordinarily apply to a Regulation D-issued security would not apply to Grams.
Defendants claimed that their position was supported by public statements by SEC Chairman Jay Clayton as well as William Hinman, SEC Director of Corporation Finance, that the initial issuance of a virtual asset – such as ether – might constitute a security offering, but the virtual asset over time could become a cryptocurrency.
The SEC brought its enforcement action despite defendants’ multiple voluntary productions of documents, meetings, and letters to the Commission from February 6, 2018 through October 11, 2019, to address issues raised by the agency’s staff. Notwithstanding, the SEC never provided “clear guidance and fair notice” that Gram tokens might be considered a security, and the SEC’s prosecution constitutes improper “regulation by enforcement,” claimed defendants.
(Click here for background on the SEC’s enforcement action in the article “Defendants Formally Stipulate to a Delay in Digital Asset Distribution That SEC Alleged Constituted an Unregistered Offering” in the October 20, 2019 edition of Bridging the Week.)
In other legal and regulatory developments involving Fintech:
Under the licensing regime for trading platforms, an eligible operator may apply for a license and, if granted, would operate in SFC’s regulatory sandbox “for a period of close and intensive supervision.” To qualify for a license, the operator would have to agree to limit its facilities to professional investors and provide access solely to persons with “sufficient knowledge” of cryptoassets; to maintain strict criteria for the inclusion of virtual assets for trading; and to utilize a “reputable” external market surveillance system. Additionally, the platform would have to apply prevailing know-your-customer, anti-money laundering and counter-financing of terrorism standards and have adequate policies and practices dealing with accounting and auditing, risk management and conflicts of interest. The platform would also have to maintain insurance to cover 100 percent of the risks of custody of virtual assets in hot storage and “substantial” coverage (e.g., 95 percent) of the risks of custody of virtual assets in cold storage. SFC’s requirements for licensed entities would apply to trading involving virtual tokens constituting both securities and non-securities.
Separately, SFC announced that, going forward, it will require all HK funds that invest in virtual assets that are not securities or futures to be licensed and, along with currently licensed funds that trade similar virtual assets, generally be subject to terms and conditions applicable to funds that currently trade securities or futures exclusively (e.g., disclosure of risks; safeguarding of assets; reasonable portfolio valuation methodology; risk management; use of auditors; and maintenance of sufficient liquid capital). These licensing conditions will apply to funds with a stated investment objective to invest solely in virtual assets or an intention to invest more than 10 percent of their gross asset value in cryptoassets. Distributors to HK persons of funds organized anywhere that invest in relevant virtual assets will also require licensing and be required to apply suitability standards.
My View: Both Jay Clayton, Chairman of the SEC, and William Hinman, Director of the SEC’s Division of Corporation Finance, have acknowledged the characteristic of virtual assets might evolve over time, changing the nature of a cryptoasset from a security to a non-security. Both persons referenced the virtual asset ether as an example of such a cryptoasset. (Click here for background in the article “SEC Chairman Concurs With Division Head That a Cryptoasset’s Regulatory Classification May Morph Over Time” in the March 17, 2019 edition of Bridging the Week.) However, neither Mr. Clayton nor Mr. Hinman, nor the SEC and its staff, have issued precise guidance on when that transition occurs. SEC staff attempted to provide some guidance in a “Framework for ‘Investment Contract’ Analysis of Digital Assets” issued earlier this year, but the guidance was imprecise at best. (Click here for background in the article “SEC Staff Outlines Characteristics of Cryptoassets That Could Cause Them to Be Regarded as Securities” in the April 7, 2019 edition of Bridging the Week.) Indeed, Hester Peirce, another SEC commissioner, criticized the Framework claiming its "Jackson Pollock approach to splashing lots of factors on the canvas without any clear message leaves something to be desired." (Click here for background in the article "SEC Crypto Guidance Employing Jackson Pollock Techniques Too Cryptic Says Commissioner Hester Peirce" in the May 12, 2019 edition of Bridging the Week.)
This ambiguity – which is at the heart of the conflict between the Telegram Group and the SEC – contrasts with the precision of the definition of a narrow-based security index which is used to determine when a futures contract based on a security index is broad-based and under the jurisdiction of the Commodity Futures Trading Commission or narrow-based and under the joint jurisdiction of the CFTC and the SEC. (Click here to access 15 U.S.C. § 78c(a)(55)(B).) Generally, in the former case, the futures must be listed on a designated contract market unless exempt while in the latter case, the security futures must be registered and listed on a national securities exchange unless exempt.
This provision of law was key to a 2013 determination by the SEC that Eurex Deutschland – a non-US exchange and a non-registered DCM – violated Section 21(a) of the Securities Exchange Act (click here to access 15 U.S.C. § 78f(h)(1)) when it failed to qualify with the SEC a futures contract offered to US persons initially based on a broad-based index of non-US bank sector stocks. Eurex previously was authorized by the CFTC to directly offer and sell the futures contract to US persons without qualifying as a DCM because the derivative was based on a broad-based stock index that included no US companies. Over time, the weighting of stocks in the index changed, causing the index to become narrow-based and Eurex failed to spot this, qualify as a national securities exchange to offer the security futures to US persons (unless exempt); and qualify its security futures contracts with the SEC as required.
Notwithstanding, the SEC did not bring an enforcement action against Eurex, but solely issued a report of investigation advising the exchange of its violation and warning it (as well as other persons) to be mindful of the SEC’s requirements and not repeat its violation. (Click here for background in the section “My View” to the article “CFTC Issues Explanation of Its Oversight and Approach to Virtual Currency Markets; Texas Securities Board Enjoins Initial Coin Offering" in the January 7, 2018 edition of Bridging the Week.)
Contrast this with the approach of the SEC against Telegram.
The SEC might very well claim that it warned the industry of its views regarding virtual assets possibly being investment contracts in a report of investigation involving the DAO in 2017. (Click here for background in the article “SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issued in Accordance with US Securities Laws” in the July 26, 2017 edition of Between Bridges.) However, that situation involved a static virtual asset and not one that may (or may not) have had different attributes over time.
The SEC should more carefully tread in areas of Fintech innovation and not use its enforcement authority as a sledgehammer to create new regulations where the law is unclear at best. Not only is this technique fundamentally unfair, but it deprives parties of due process.
Simultaneously, the company entered into a deferred prosecution agreement (“DPA”) with the Department of Justice related to the same activities by also agreeing to pay US $67.4 million as a criminal fine, criminal disgorgement and victim compensation. However, under the CFTC settlement, any amounts paid by Tower to the DOJ will offset amounts otherwise owed to the CFTC. Under the DPA, Tower is additionally required to continue to enhance its compliance program, addressing certain enumerated elements (e.g., high-level commitment; policies and procedures; periodic risk-based review; proper oversight and independence; training and guidance; internal reporting and investigation; enforcement and discipline; and monitoring and testing).
According to the CFTC, the three traders engaged in spoofing trading “on thousands of occasions” during the relevant time on futures contracts listed on two CME Group exchanges. Typically the traders showed small visible quantities on one side of the market using iceberg orders, while placing a larger quantity of total orders on the opposite side of the market that the traders intended to cancel as soon as their smaller orders were executed. The CFTC claimed that the traders often used an order splitter to break their spoofing orders into random-sized orders to better disguise their spoofing scheme.
Previously, Tower agreed to pay a fine of US $150,000 and disgorge profits of US $162,000 to resolve disciplinary actions by four CME Group exchanges for spoofing activities by the same ex-traders that occurred within a portion of the time period covered by the CFTC and DOJ action. (Click here for background in the article “CME Group Exchanges Bring Disciplinary Actions Charging Wash Sales, Money Passes and Disruptive Trading and Failure to Follow Audit Trail Requirements” in the November 12, 2017 edition of Bridging the Week.)
The three ex-Tower traders – Kamaldeep Gandhi, Krishna Mohan and Yuchun Mao – have been criminally charged for their conduct. Mr. Gandhi and Mr. Mohan previously pleaded guilty to charges and await sentencing, while a criminal action against Mr. Mao is pending. (Click here for background in the article “Three Traders Plead Guilty to Spoofing Violations” in the November 11, 2018 edition of Bridging the Week.)
Both the CFTC settlement and DOJ DPA acknowledged Tower’s cooperation in their investigations, as previously had the CME Group exchanges’ disciplinary actions. The DOJ additionally noted Tower’s “extensive remedial efforts”; termination of the traders; and “significant investments in sophisticated trade surveillance tools” and other “extensive” remedial measures, including changes in senior management, in publicizing why it determined to resolve the criminal matter.
Unrelatedly, Mitsubishi Corporation RtM Japan Ltd. consented to pay US $500,000 to settle CFTC charges that it engaged in spoofing activities through the activities on one trader from at least April 5 through April 13, 2018. The New York Mercantile Exchange resolved a parallel disciplinary action against Mitsubishi for the same conduct by the same trader for a slightly longer period of time – April 5 through 18, 2018. Mitsubishi agreed to pay a fine of US $250,000 to resolve the NYMEX matter.
According to the CFTC, during the relevant time the relevant trader – who was unnamed – was on secondment to Mitsubishi in its Tokyo office. While there, and on temporary leave from business development duties, the individual was placed on a trading desk that traded precious metals. There he allegedly engaged in spoofing transactions involving platinum and palladium futures. According to NYMEX, the trader did not receive “sufficient US regulatory guidance or oversight” and the firm failed specifically to train the trader regarding CME Group markets.
The CFTC said that Mitsubishi was advised of the potential spoofing activity by its trader by its futures commission merchant. Afterwards, Mitsubishi conducted an investigation into the matter; cooperated with the CFTC’s investigation; and instituted a number of remedial measures, including implementing an electronic trading monitoring system.
My View: In both the Tower and Mitsubishi settlements, regulators credited the firms for their cooperation in their investigation and the adoption of comprehensive remedial measures. However, the sanctions in both cases were still very large – for Tower, “the largest total monetary relief ever ordered [in a spoofing case],” said the CFTC, and for Mitsubishi, a relatively large fine for a very few number of days of problematic activity. Moreover, the amounts of each fine seem arbitrary and not grounded in a clear basis. As a result, credit may have been given for the firms’ cooperation, but the benefit is not apparent.
In a recent speech at FIA Expo, CFTC Chairman Heath Tarbert intimated that the Division of Enforcement would soon be publishing enforcement penalty guidelines. It would be helpful if these guidelines explain how the DOE determines its asking price for settlements, and how cooperation precisely factors into final settlement calculations. Today, these determinations are not transparent at all and potential defendants are often dumbfounded when staff first proposes a settlement amount in resolution negotiations. (Click here for background regarding Dr. Tarbert’s FIA presentation in the article “CFTC Chair Says Position Limits Proposal Coming Soon; Head of DSIO Says Thematic Reviews Coming Soon Too” in the November 3, 2019 edition of Bridging the Week.)
In addition to agreeing to pay the US $10 million fine, WFB agreed to restitution to its counterparty of US $4.475 million to resolve the CFTC’s enforcement action. However the amount of ordered restitution was deemed satisfied by prior restitution by WFB to the counterparty.
Previously, WFB agreed to pay NFA US $2.5 million as a fine to resolve its enforcement proceeding. (Click here for background regarding the NFA’s action in the article “Swap Dealer Sanction US $2.5 Million by NFA for Providing Customer Misleading Information Regarding Forward Contract Pricing" in the August 11, 2019 edition of Bridging the Week.)
My View: It makes no sense to formally order restitution by a defendant in an enforcement action where the restitution previously was voluntarily made by the defendant, other than to garner headlines of a bigger aggregate penalty. The CFTC’s press release heralding WFB's settlement (click here to access) separately disclosed the order of restitution and amount in the body of text and incorporated the amount in the headlined amount of the overall sanction – "over $14 million" (i.e., the aggregate amount of the fine and restitution), but made no reference to the prior voluntary payment by WFB to its counterparty (although the settlement order referenced this). The order of restitution here – where WFB previously paid-back the counterparty – appears unnecessary and the press release compounds the unfairness and seems at least a bit misleading.
Regarding advertisements, the amended rule would broaden the definition of advertisement to account for new technologies and evolving practices and include general prohibitions such as the making of any material untrue statement or omission of a material statement that would make a statement not misleading as well as including or excluding performance results or presenting performance results for time periods in a way that is not “fair and balanced.” There are other prohibitions recommended for performance information.
Proposed amendments to the solicitation rules include requirements for written agreements between an adviser and all solicitors; obligations by solicitors to disclose their financial interest in a client’s choice of an adviser; and obligations of advisers regarding their oversight of solicitors.
Comments to the SEC’s proposal will be accepted for 60 days after its publication in the Federal Register.
The CFTC also approved three foreign boards of trade for direct access by US persons –Euronext Amsterdam N.V. of the Netherlands, Euronext Paris SA of France and the European Energy Exchange of Germany. The CFTC approved these FBOTs because, among other things, they are subject to oversight by foreign regulators which is comparable to CFTC oversight over designated contract markets. CFTC Commissioner Brian Quintenz objected to the approvals, however, because of the current refusal of European regulators to re-affirm the 2016 commitment of the CFTC and the European Commission to a common approach to the regulation of cross-border central counterparties. According to Mr. Quintenz, “FBOT registration depends on the CFTC’s trust in our E.U. counterparts. Such trust continues to be misplaced until the E.U. can provide assurance that the CFTC-EC CCP Agreement will be upheld.” Mr. Quintenz made clear he does not disagree with the substance of the three FBOTs’ approvals, but only their timing.
Previously, AOT Holding AG filed a putative class action lawsuit against ADM alleging that, from November 2017 through the present time, ADM routinely manipulated a principal ethanol pricing benchmark – the Chicago Ethanol (Terminal) price – and three derivatives contracts traded on CME Group exchanges whose settlement prices were either based on or influenced by the benchmark. AOT claimed that this manipulation occurred when ADM routinely sold large quantities of ethanol during a specific time each day to influence the benchmark price, which itself helped ADM maximize the value of its large short CME derivatives positions. AOT claimed this conduct was inconsistent with ADM’s physical holdings of ethanol as it reduced the firm’s profit margins and decreased prices below ADM’s variable cost of production. (Click here for background on AOT’s lawsuit in the article “Putative Class Action Lawsuit Filed Against Major Ethanol Producer for Purported Manipulation of Key Ethanol Benchmark and Three-CME Group Exchanges Ethanol Futures Contracts" in the September 9, 2019 edition of Bridging the Week.)
In its motion to dismiss, ADM observed that, during the relevant time, there was a “supply glut” of ethanol and this caused prices of ethanol to decline. According to ADM, AOT lost money going long against the market, expecting market prices to recover “and the price did not rise.” ADM noted that AOT based its allegations solely on two days of activity during an alleged prolonged period of wrongdoing. On the first day, AOT faulted ADM for accepting a buyer’s proactive bids to buy ethanol, when the buyer was AOT itself, claimed ADM. On the second day, ADM sold ethanol, but to buyers at the highest bids of the day. As a result, based on these two days, AOT cannot argue that ADM manipulated the price downwards, claimed ADM.
Previously, Lek Securities Corp. and Sam Lek, its chief executive officer, settled charges also brought by the SEC that they facilitated manipulation by Avalon and the two control persons. To resolve the SEC’s complaint, Lek Securities agreed to pay a fine of US $1 million and US $525,892 in disgorgement and prejudgment interest and Mr. Lek consented to remitting a US $420,000 fine. Lek Securities also agreed to certain other sanctions including not providing intraday-trading access to foreign customers except under limited prescribed circumstances, and retaining a compliance monitor for three years. (Click here for details regarding Avalon’s alleged manipulative schemes in the article “Broker-Dealer and CEO Agree to Almost US @$2 Million Penalty with SEC for Facilitating Alleged Manipulative Trading by Non-US-Based Trading Firm" in the October 13, 2019 edition of Bridging the Week.)
Unrelatedly, Merrill Lynch International agreed to pay a fine of US $200,000 to ICE Futures U.S. to resolve allegations that, on multiple occasions from June through September 2018, it may not have reported block trades within required time frames; may not have explicitly advised a client that an order was to be executed as a block trade; and for failure to supervise. Oil Brokerage Limited also consented to a settlement with IFUS related to its handling of block trades. According to IFUS, between August and December 2018, the firm may have failed to meet certain minimum thresholds for block trades in certain energy contracts; not complied with order ticket requirements, as well as obligations to record and maintain all written and/or oral communications leading to the execution of a block trade; not adhered to time frames to report block trades; disclosed the identity of customers to block trades without their permission; and failure to supervise. Oil Brokerage agreed to pay a fine of US $70,000 to resolve IFUS’s allegations.
Additionally, Dunn Capital Management also resolved a disciplinary action by IFUS by agreeing to pay a fine of US $40,000. IFUS claimed that between September 2016 and May 2017 one of its former employees – apparently Thomas Jendras – while using the trader ID of another employee, may have entered and cancelled orders during pre-open periods to assess the impact of the orders on the indicative open price and not to trade. Mr. Jendras separately agreed to a six-month IFUS access ban to settle a parallel disciplinary action filed against him based on the same facts. Dunn Capital was also charged by IFUS with failure to supervise.
Finally, two individuals – Christopher Mitchell and Nolan Conover – were charged by IFUS with possibly entering orders at off-market prices to ascertain market depth, and not with an intent to trade on multiple occasions from May through September 2018. Mr. Mitchell agreed to pay US $22,500 to settle his matter, while Mr. Conover consented to a US $17,500 fine.
For further information:
AFME Recommends "Greater Supervisory Convergence" For Regulation of Cryptoassets in Europe:
Agriculture Merchant Asks for Dismissal of Private Complaint Alleging Manipulation of Ethanol Futures Claiming Plaintiffs Solely Seek to Recover for “Own Bad Bets”:
CFTC Proposes Fix to Customer Privacy Rules to Require Relevant Written Policies and Procedures; Approves Three Foreign Boards of Trade Over One Commissioner’s Dissent:
CFTC Submits Suggestion of Mootness Regarding Potential Contempt Determination Against It:
Foreign Company Client of US Broker-Dealer Previously Sanctioned by SEC Loses Civil Enforcement Action Alleging Manipulative Trading for Layering:
Freshening of Investment Adviser Advertising and Solicitation Requirements Proposed by SEC:
Hong Kong Financial Regulator to Require Licensing of All Portfolio Firms Investing in Virtual Assets Whether Futures or Securities:
IOSCO Encourages Stablecoin Issuers to Engage With Relevant Regulatory Bodies Prior to Issuance:
Messaging Service Company Denies SEC’s Claim That Sale and Issuance of Cryptocurrency Constitutes Unlawful Security Offering:
NYMEX Summarily Bars Company and Individuals From All CME Group Exchanges for 60 Days for “Anomalous” Trading and Non-Full Cooperation With Exchange Investigation:
Dunn Capital Management:
Merrill Lynch International:
Oil Brokerage Limited:
3 Crowns Capital:
Proprietary Trading Firm Hit With Combined $67.4 Million Penalty to Resolve DOJ and CFTC Spoofing Allegations:
SEC Highlights Legal Actions Involving ICOs and Digital Assets in Summary of FY 2019 Enforcement Highlights:
Swap Dealer Sanctioned by CFTC for Purported Business Conduct Violations Months After NFA Assesses Related Fine:
Order: Wells Fargo Bank, N.A.
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of November 16, 2019. 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. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or employees.
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.
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Bridging the Week by Gary DeWaal: November 4 to 15, and November 18, 2019 (Cryptocurrency or Security; Spoofing; Double Jeopardy; Restitution)Jump to: APAC Regulation (sans Capital and Liquidity) Bitcoin Ecosystem Block Trades and EFRPs Bridging the Week Cryptosecurities Cybersecurity EMEA Regulation (sans Capital and Liquidity and UK after March 1, 2019) Managed Money Manipulation My View Policy and Politics Trade Practices (including Disruptive Trading) Uncleared Swaps