Steven Seagal just learned the hard way that, unlike the title of his 1988 police action movie, he is not Above the Law. Unfortunately for the prolific action movie star, the SEC took notice of his recent actions and was Out for Justice. In order to avoid a Maximum Conviction, the SEC recently announced that Seagal made the Executive Decision to settle charges brought by the agency related to the actor’s failure to disclose the nature, scope, and amount of compensation he received for promoting an investment in an initial coin offering (ICO) conducted by Bitcoiin2Gen.
“The definition of ‘commodity’ is broad. Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.” (In re Coinflip, Inc., CFTC No. 15-29 (Sept. 17, 2015)). This has been the view of the Commodity Futures Trading Commission (CFTC) since at least 2015, and the courts increasingly appear to be affirming the Commission’s assertion of jurisdiction over the virtual currency market.
The U.S. District Court for the District of Massachusetts is the latest court to rule that virtual currencies are commodities, and subject to CFTC jurisdiction. (See CFTC v. My Big Coin Pay, Inc, 1:18-CV-10011-RWZ). In My Big Coin, the district court entered an order holding that the CFTC has the power to prosecute fraud involving virtual currency, even in instances where there is no futures contract over the relevant virtual currency.
A “commodity” as defined in the Commodities Exchange Act (CEA) includes a list of enumerated agricultural products, “and all other goods and articles… and 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 defendants argued that a commodity under this definition required the specific item at issue be the subject of a futures contract. The only existing futures are on Bitcoin (CME’s BTC and CBOE’s XBT), no other virtual currency currently underlies a futures contract. Because contracts for future delivery were not “dealt in” the virtual currency at issue, My Big Coin (MBC), defendants argued MBC could not be a commodity under the CEA. The court rejected the defendant’s argument, holding that the “CEA only requires the existence of futures trading within a certain class… to be considered commodities.”
This holding is consistent with an earlier decision in the Eastern District of New York, where the court found virtual currencies fell “well-within” the definition of commodity, and can therefore be regulated by the CFTC. (See CFTC v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018)).
McDonnell is distinguishable from My Big Coin, in that McDonnel involved alleged fraud in connection with Bitcoin, a virtual currency with an existing futures market. This distinction was apparently not relevant to the court in My Big Coin. It ruled that if futures contracts exist within a certain class of commodities (such as virtual currency), then all items within that class are considered commodities under the CEA.
“[MBC] is a virtual currency and it is undisputed that there is futures trading in virtual currencies (specifically involving Bitcoin). That is sufficient…to allege that [MBC] is a ‘commodity’ under the Act.” (See My Big Coin, 1:18-CV-10011-RWZ).
It is important to note the court also rejected Defendant’s argument that the CFTC’s anti-fraud authority under Section 6(c)(1) of the CEA extended only to fraudulent market manipulation, holding that the “broad language in the statute” “explicitly prohibit[s] fraud even in the absence of market manipulation.”
Section 6(c) of the CEA, and the ancillary CFTC rule 180.1, prohibit the use of any manipulative or deceptive device or contrivance in connection with transactions involving commodities in interstate commerce. 17 C.F.R. §180(a)(1)-(3). The CFTC has looked to assert this authority not only over instances of fraud in the cash commodity market that manipulates the derivatives market, but also in instances of fraud where no market manipulation, or even a relevant futures market, exists.
This finding again was consistent with the McDonnell court, which faced a similar argument. Not all courts who have decided this issue, however, are in agreement. In May this year a US District Court for the Central District of California found that “the CEA unambiguously forecloses the application of 6(c)(1) in the absence of actual or potential market manipulation. (CFTC v Monex, SACV 17-01868 JVS). This decision is being appealed by the CFTC.
The rulings in My Big Coin and McDonnell are particularly broad, and extend CFTC jurisdiction not only over all virtual currencies, but over all fraud in such virtual currencies, regardless of any impact or manipulation on a futures contract. The CFTC, however, is not the only regulator looking to assert or extend its enforcement rights over virtual currency market participants. There have been a series of recent enforcement actions announced by the CFTC, SEC and FINRA.
First, the SEC entered an order finding that Crypto Asset Management LP (CAM) offered a fund that operated as an unregistered investment company while falsely marketing it as the “first regulated crypto asset fund in the United States.” According to the SEC’s order, hedge fund CAM raised more than $3.6 million over a four-month period in late 2017 while falsely claiming that it was regulated by the SEC and had filed a registration statement with the agency. By engaging in an unregistered non-exempt public offering and investing more than 40 percent of the fund’s assets in digital asset securities, CAM caused the fund to operate as an unregistered investment company.
Second, the SEC settled charges against another firm and its owners for violations of the Securities Exchange Act. Specifically, the Commission found a platform that brokered both secondary purchases of virtual currencies and sales of ICOs was improperly operating as an unregistered broker/dealer. This was the SEC’s first case charging unregistered broker-dealers for selling digital tokens after the SEC issued The DAO Report in 2017 cautioning that those who offer and sell digital securities must comply with the federal securities laws.
Additionally, the SEC and CFTC filed charges in separate complaints against a virtual currency dealer based in the Marshall Islands and its Austrian based CEO for various federal regulatory violations, including: failure to properly register as a security-based swaps dealer, failure to properly register as a FCM, and failure to properly maintain adequate anti-money laundering procedures.
Finally, FINRA announced charges against an individual for selling virtual currency that was not properly registered as a security. These charges followed FINRA’s recent request for member firms to voluntarily disclose their virtual currency activities (see previous remarks here). FINRA asked firms to not only disclose their activity, but the outside virtual currency business activities of their associated persons.
The recent caselaw and regulatory actions continue the trend towards more regulatory oversight of the virtual currency market. While the McDonnell and My Big Coin holdings appear far-reaching, they (along with the enforcement actions of other regulators) have provided some clarity to the market participants.
The National Futures Association (“NFA”) recently proposed an interpretive notice updating disclosure requirements for its members engaged in virtual currency (i.e. cryptocurrency) activities. Self-Regulatory Organizations are increasingly interested in their members’ activities in the emerging virtual currency market, with the NFA’s notice following on the heels of a FINRA Regulatory Notice encouraging its members to self-report their virtual currency activities. (See here for detail on FINRA’s notice).
The apparent catalyst for the NFA’s recent proposal was the launch of bitcoin futures by the CME and CBOE Futures Exchange in December 2017. Concerned that the growth of the market has attracted investors that may not fully appreciate the substantial risk of loss that may rise from trading virtual currencies, and the NFA’s limited regulatory oversight authority, the NFA developed the enhanced disclosure requirements for members.
According to the NFA’s interpretive notice, virtual currencies and virtual currency derivatives have a variety of unique and potentially significant risks. These risks include price volatility, valuation and liquidity sourcing issues as a result of the decentralized and opaque spot market, unregulated intermediaries and custodians, an uncertain regulatory landscape, and security of assets due to nascent technology. The proposed disclosures are intended to educate and warn customers of these unique risks.
As outlined, a member would have different disclosure requirements based upon its registration status, and virtual currency activities.
Futures Commission Merchants (“FCM”) and Introducing Brokers (“IB”)
Under the notice, FCMs and IBs engaged in virtual currency derivatives activities must provide both the NFA’s Investor Advisory Futures on Virtual Currencies Including Bitcoin, and the CFTC’s Customer Advisory Understanding the Risk of Virtual Currency Trading to any customer that is engaged, or intends to engage in, virtual currency derivative trading with or through the FCM or IB.
FCMs and IBs engaging in activities with customers or counterparties involving spot virtual currencies must provide customers and counterparties the standardized disclosure language outlined in the notice.
Commodity Pool Operators (“CPO”) and Commodity Trading Advisors (“CTA”)
CPOs and CTAs are required to draft and provide robust disclosures related to the risks of virtual currencies and virtual currency derivatives. To help ensure this, the notice provides guidelines of risks that a CPO/CTA must address, but the NFA cautions that the guidelines are not exhaustive, and members should tailor their disclosures to address the specific risks associated with the particular activity they intend to engage in.
For a CPO/CTA engaged in virtual currency transactions, it must provide not only standardized language outlined in the notice, but additional disclosures in their offering documents or promotional materials that address the following areas:
- Unique features of virtual currencies
- Price volatility
- Valuation and liquidity
- Opaque spot market
- Virtual currency exchanges, intermediaries and custodians
- Regulatory landscape
- Transaction fees
Finally, any CPO/CTA engaged in any manner in activities with customers or counterparties involving spot virtual currencies not outlined in the notice must provide an additional standardized risk disclosure.
The guidance will take effect in 10 days unless the CFTC initiates a review. The full text of the proposed interpretive notice can be found here.
UPDATE: The NFA has set October 31, 2018 as an effective date for the disclosure requirements outlined in its interpretive notice for members engaged in virtual currency actives. To ensure members understand their updated obligations, the NFA indicated in its Notice to Members announcing the effective date that it will be providing member education on the new requirements prior to October 31st.
“I believe every ICO I’ve seen is a security and we have jurisdiction and our federal securities laws apply.” Clayton, J., Testimony, Sen. Banking, Housing and Urban Affairs Committee (Feb. 6, 2018). This was SEC Chairman Jay Clayton’s testimony on February 6, 2018 to the Senate Banking Committee in a hearing on the SEC oversight of virtual currencies. The Chair’s sentiments in February were in line with the SEC’s historic approach to asserting jurisdiction over the nascent cryptocurrency marketplace. Beginning as early as 2013, the SEC began issuing investor alerts asserting the Commission’s jurisdiction over cryptocurrencies that functioned as securities. SEC Investor Alert, Ponzi Schemes Using Virtual Currencies, July 1, 2013. This early assertion of jurisdiction has been confirmed through the SEC’s position in the DAO Report, and reinforced through multiple SEC enforcement actions.
Four months after the Chair’s comments before the Senate Banking Committee, there are signs that the SEC is refining its opinion on the extent of its jurisdiction. Last week, Chairman Clayton stated that Bitcoin and cryptocurrencies like Bitcoin are not securities. See link here. This in itself is not particularly progressive. Bitcoin has widely been considered only an asset used as a store of value or method of payment, and it was never subject to an ICO. The CFTC has already claimed Bitcoin as a commodity, and even called it a currency (though in a twist of regulatory nuance it is not a “foreign” currency). See In re Coinflip, Inc., CFTC No. 15-29 (Sept. 17, 2015), See In re BFXNA Inc., d/b/a Bitfinex, CFTC No. 16-19 (Jun. 2, 2016). Nevertheless Clayton’s recent comments are some of the most concrete “no action” language the market has heard from the SEC regarding cryptocurrencies.
Last week, there was even more interesting news. William Hinman, the Director of the Division of Corporation Finance, in prepared remarks stated that “based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.” Full speech available here. Behind Bitcoin, Ether is the next largest traded cryptocurrency by volume (see market cap statistics here), and many other cryptocurrencies utilize the Etherium structure and employ Ether as a method of payment or investment. With Clayton and Hinman’s comments the SEC is providing the market some needed clarity on the Commission’s jurisdictional limits. As expected, the market reacted positively to news, with Ether’s price rising 10% intra-day, and Bitcoin rising 6%.
Hinman’s speech is significant for another reason. Ether started out as an ICO. Development of the Etherium network was funded by participants purchasing Ether. Over time, however, Ether’s characteristics have changed; it is produced exclusively through mining efforts, and the network it operates on is decentralized. Ether has essentially morphed into a method of payment more akin to Bitcoin. Hinman addresses this change in his speech, and concedes that coins can change over time from an ICO to a currency. He specifically emphasizes “that the analysis of whether something is a security is not static and does not strictly inhere to the instrument.”
It is uncertain how the SEC would seek to regulate a security that, over time, transforms into a currency or from a currency into a security, but this concession from the Commission is important for the crypto space as it provides some needed guidance to the marketplace.
On April 6, 2018, the Securities and Exchange Commission (SEC) obtained a court order freezing more than $27 million in proceeds from alleged illegal distributions and sales of restricted shares of a public company, and charged the company, its CEO, and three other affiliated individuals. That same day, the Nasdaq Stock Market said it halted trading in the company’s stock. The SEC’s complaint alleges that shortly after the company began trading on the Nasdaq Stock Market and announced the acquisition of a purported blockchain-empowered cryptocurrency business that its stock price rose dramatically until its market capitalization exceeded $3 billion. The SEC further alleges that the CEO and the three other individual defendants then illegally sold large blocks of their restricted shares to the public while the stock price was excessively elevated and that they collectively reaped more than $27 million in profits.
By way of background, and as alleged by the SEC, the company went public under a scaled-down version of a traditional initial public offering known as Reg A+ late last year. In December 2017, the company’s Class A shares began trading on the Nasdaq Stock Market. Two days later, the company announced that it had acquired the purported blockchain-empowered cryptocurrency business from another entity. The SEC alleges that one of the individual defendants held at least a 92% stake in this entity. The SEC further alleges that — notwithstanding that this acquired business had no ascertainable value — the company’s stock price rose excessively and quickly after said acquisition. Specifically, by December 18, 2017, the company’s stock price rose to a high of $142.82 per share; an increase of nearly 550% from the prior day’s closing price and about 2,670% above the company’s closing price on its first day of trading just several days earlier.
This action serves as yet another example of the SEC’s heightened and aggressive focus in this area. As we discussed previously on this blog, one of the focus areas for the SEC’s Cyber Unit that was created just last September is “Violations involving distributed ledger technology and initial coin offerings.” More recently, the financial press reported that the SEC had launched a “sweep” in this area by serving subpoenas and information requests on technology companies and investment management firms and brokers doing business in the virtual currency markets.
Returning to the SEC’s $27 million freeze action here, the SEC alleged only registration offering violations against the defendants. This may not be the last of the charges, however, as the SEC described this as a “continuing investigation” in its press release.