Bridging the Week by Gary DeWaal: October 15 - 19 and October 22, 2018 (Bitcoin Fraud; Smart Contracts; Actual Delivery; Reg AT)

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Published Date: October 21, 2018

The Commodity Futures Trading Commission obtained orders from a federal court in New York concluding its first-filed enforcement action against persons for bitcoin fraud. However, the outcome of an unrelated action having nothing to do with cryptocurrencies and pending in a federal court of appeals in California may have greater implications for the CFTC’s cryptocurrency enforcement efforts going forward. Separately, CFTC Chairman J. Christopher Giancarlo announced before an industry gathering last week that Reg AT – a 2015 Commission proposal to augment regulations regarding algorithmic trading purportedly to mitigate risks – was officially dead. Likely, no algorithmic traders mourned. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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In September 2017, the CFTC filed charges against Gelfman Blueprint and Mr. Gelfman for conducting an alleged Ponzi scheme involving bitcoin. This enforcement action represented the first time the CFTC used its authority granted under the Dodd-Frank Wall Street Reform and Consumer Protection Act to prosecute an alleged manipulative or deceptive device or contrivance in connection with a cryptocurrency in interstate commerce. (Click here to access CEA Section 6(c)(1), 7 U.S.C. § 9(1).) No derivative based on a cryptocurrency was alleged to have been involved.

The Commission claimed that from January 2014 through January 2016, the defendants solicited approximately US $600,000 from at least 80 customers to trade bitcoin in a pooled fund using a proprietary algorithm called “Jigsaw.” However, charged the CFTC, the defendants misappropriated most of this money for their own use and rarely traded for customers. The defendants also misled investors and potential investors through false and misleading statements.

Mr. Gelfman personally consented to an order of permanent injunction and imposition of a fine, restitution and a trading ban to resolve the CFTC’s enforcement action. The court approved an equivalent default order against Gelfman Blueprint. Under the terms of their orders, Gelfman Blueprint and Mr. Gelfman are required to pay fines and restitution of more than US $2.5 million, combined. Previously, Mr. Gelfman pleaded guilty to one count of petit larceny in connection with a New York criminal prosecution deriving from the same underlying facts as the CFTC's enforcement action.

(Click here for background regarding the CFTC’s enforcement action in the article “CFTC Files Charges Alleging Bitcoin Ponzi Scheme Not Involving Derivatives” in the September 24, 2017 edition of Bridging the Week.)

Although the CFTC's enforcement action against Gelfman Blueprint and Mr. Gelfman was the Commission's first enforcement action alleging fraud in connection with the offer and sale of cryptocurrencies, it has filed subsequent enforcement actions on a similar theme, obtaining a permanent injunction and sanctions in one case – against Cabbagetech Corp. and Patrick McDonnell – and prevailing in a motion to dismiss in another – against My Big Coin Pay, Inc., Randall Crater and certain relief defendants. (Click here for background regarding the Cabbagetech enforcement action in the article, "Federal Court Enters Final Judgment Against Alleged Virtual Currency Fraudster; Confirms CFTC Authority to Bring Enforcement Action" in the August 26, 2018 edition of Bridging the Week and here for a discussion concerning My Big Coin Pay in the article "Second Federal Court Rules That Cryptocurrencies Are Commodities and CFTC Has Anti-Fraud Jurisdiction Over Alleged Wrongdoing" in the September 30, 2018 edition of Bridging the Week.)

Among other developments involving crypto-assets this past week:

Earlier this year, Jitesh Thakkar was named in both a CFTC civil enforcement action and a Department of Justice criminal lawsuit in connection with his development of software that purportedly was used by Navinder Sarao in connection with Mr. Sarao’s alleged spoofing activities. (Click here for background in the article “CFTC Names Four Banking Organization Companies, a Trading Software Design Company and Six Individuals in Spoofing-Related Cases; the Same Six Individuals Criminally Charged Plus Two More” in the February 4, 2018 edition of Bridging the Week.)

Previously, the district court held that actual delivery of precious metals in financed transactions to retail persons falls outside the CFTC’s jurisdiction when ownership of real metals is legally transferred to such persons within 28 days – the so-called “Actual Delivery Exception”– even if the seller retains control over the commodities because of the financing beyond 28 days.

The district court also ruled that the CFTC cannot use the Dodd-Frank prohibition against persons engaging in any manipulative or deceptive device or contrivance in connection with the sale of any commodity to prosecute acts of purported fraud except in instances of fraud‑based market manipulation. (Click here for details regarding the district court’s decision in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week.)

Defendants in two recent CFTC enforcement actions charging fraud in connection with cryptocurrency activities – Patrick McDonnell and My Big Coin Pay – unsuccessfully tried to convince two different federal courts to follow the Monex district court’s reasoning to escape the CFTC’s jurisdiction.

Legal Weeds: A decision by the California federal appeals court in favor of Monex upholding the lower court’s decision would have a chilling effect on the CFTC’s enforcement efforts against persons selling virtual currencies who do so on leverage or who engage in alleged fraudulent practices. This is because such a ruling would raise questions regarding the CFTC’s authority to bring such actions in the first place.

In 2016, the CFTC settled an enforcement action against BFXNA Inc. d/b/a Bitfinex, claiming that the firm operated a platform that enabled retail persons to buy and sell virtual cryptocurrencies and to finance their transactions. However, because Bitfinex purportedly retained control over such transactions after the financing – much like the CFTC alleged against Monex – the CFTC alleged that actual delivery did not occur. As a result, the transactions were akin to futures contracts, and Bitfinex should have been registered as an FCM in order to engage in such activities, said the CFTC. (Click here for further details regarding this CFTC action in the article “Bitcoin Exchange Sanctioned by CFTC for Not Being Registered” in the June 5, 2016 edition of Bridging the Week.)

Moreover, late last year, the CFTC proposed guidance that, for sales of virtual currency to retail persons, the Commission would consider “actual delivery” to have occurred only when such persons could take “possession and control” of all purchased cryptocurrency, use it freely no later than 28 days from the date of an initial transaction and do so unencumbered. This would require neither the offeror nor the seller, or any person acting in concert with such persons, to retain any interest or control in the virtual currency after 28 days from the date of the transaction. This would presumably preclude a seller from retaining control over the cryptocurrency by having authority over a wallet containing such commodity even when the seller financed the purchase. (Click here for details regarding this proposal in the article “CFTC Proposes Interpretation to Make Clear: Retail Client + Virtual Currency Transaction + Financing + No Actual Delivery by 28 Days + No Registration = Trouble” in the December 17, 2017 edition of Bridging the Week.)

If the federal appeals court hearing the CFTC’s Monex action upheld the district court’s decision, the ruling could serve as compelling precedent for persons to challenge the CFTC’s jurisdiction over financed virtual currency transactions (as well as other financed commodity transactions) to retail persons where sellers retain control to protect their loans.

Additionally, the CFTC has liberally applied the Dodd-Frank law that prohibits the use or employment of any manipulative device, scheme or artifice to defraud, as well as the parallel CFTC rule. (Click here to access CFTC Rule 180.1) This is because the CFTC has regarded the provision of law “as a broad, catch-all provision reaching fraud in all its forms – that is, intentional or reckless conduct that deceives or defrauds market participants.”

Relying on these provisions, the CFTC has brought a wide range of enforcement actions, including the JP Morgan “London Whale” case, and cases based on allegations of illegal off-exchange metals transactions, claims of more traditional manipulation of wheat, allegations of spoofing, claims of insider trading, and more recently, other allegations of cryptocurrency fraud. (Click here for a general background in the article “CFTC Brings First Insider Trading‑Type Enforcement Action Based on New Anti‑Manipulation Authority” in the December 6, 2015 edition of Bridging the Week.)

An adverse ruling for the CFTC in the court of appeals hearing Monex could force the CFTC to more narrowly focus its enforcement activities under the Dodd-Frank provision, restricting the Commission to bring lawsuits only where it can allege that a purported fraud affected the market or constituted fraud-based market manipulation. 

The CFTC initially proposed Reg AT in November 2015. The provisions, if adopted, would have imposed extensive new requirements on certain existing CFTC registrants that used automated trading systems, required the first-time registration as a floor trader of many persons who used algorithmic trading systems to electronically and directly route orders to designated contract markets, and allowed for the inspection without subpoena by the CFTC and Department of Justice of proprietary algorithmic trading systems’ source code. The CFTC proposed an amended version of Reg AT in November 2016. (Click here for background on both the initially proposed and revised versions of Reg AT in the article “Proposed Regulation AT Amended by CFTC; Attempts to Reduce Universe of Most Affected to No More Than 120 Persons” in the November 6, 2018 version of Bridging the Week.)

Reaction to the CFTC’s proposed initial and amended rules to address algorithmic trading was mostly unfavorable. (Click here for a summary of reactions to the CFTC’s amended version of Reg AT in the article “Supplemental CFTC Regulation AT Proposal Generally Criticized as Too Prescriptive” in the May 7, 2017 edition of Bridging the Week.)

Mr. Giancarlo indicated that he would be “quite open” to consider whether any elements of proposed Reg AT might serve as a basis for another more effective rule that addressed risks of automated trading. 

My View: Reg AT was a no-go from the start.

At the time it proposed Reg AT, the CFTC acknowledged the multitude of existing best industry practices and many rules and requirements of designated contract markets and the National Futures Association already in place to mitigate the risks of algorithmic trading. Notwithstanding, the Commission recommended piling on additional layers of highly detailed requirements that would have added, at most, marginal benefits, while imposing substantial additional costs.

Moreover, in an effort to enhance compliance with what are now best practices, the CFTC potentially would have caused some trading firms to consider not implementing new and innovative risk control procedures and even rolling back already relied-on best practices. This is because the CFTC initially proposed to elevate to a regulatory incident the failure of an AT Person to comply with its own compliance procedures, in addition to relevant law and rules. This would have discouraged algorithmic trading firms from implementing as a formal requirement any best practice above a CFTC minimum requirement, when its reward for being innovative and top in class could be a potential regulatory violation and sanction.

Most egregious, the requirement that AT Persons make available their source code to CFTC and US Department of Justice staff for inspection — not solely pursuant, as now, to subpoena or other lawful process of law — was a substantial if not unconstitutional overreach, opening AT Persons to potential compromises of their proprietary innovations.

The better way to achieve many of the good objectives of Reg AT has always been to build upon approaches already implemented by DCMs and the NFA, let alone by the proprietary trading industry itself, and to encourage the development and implementation of further best practices rather than construct a new regulatory infrastructure.

Mr. Giancarlo objected to Reg AT when it was proposed, and fortunately has formally killed the proposal entirely now.

More Briefly:

For further information

CBOE Exchanges Fine Member for Not Stopping Excessive Order Messaging Activity:

CFTC Concludes First Bitcoin Anti-Fraud Enforcement Action With Assessment of Over US $2.5 Million in Fines and Restitution:

FinCEN Employee Arrested and Criminally Charged for Leaking Confidential SARs to Reporter:

Global Banking Supervisors Seek Views on Modifying Capital Treatment of Customer Collateral for Centrally Cleared Derivatives:

Multiple Nonmembers Held Liable for Disruptive Trading by NYMEX and COMEX and for Not Participating in Disciplinary Process:

Public Companies Warned by SEC of Consequences If Cyber-Attacks Are Determined Attributable to Lax Internal Controls:

Reg AT Dead Proclaims CFTC Chairman:

SEC-CFTC Harmonization Briefing Hosted by Two CFTC Commissioners Not Violative of Sunshine Act Rules CFTC Inspector General:

SEC Rules Against Two Exchanges Raising Market Data Fees:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of October 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. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or other employees.



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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.

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