Bridging the Weeks by Gary DeWaal: October 30 – November 10 and November 13, 2017 (Initial Coin Offerings; Price Disclosure; Wash Sales; Audit Trails)

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Published Date: November 12, 2017

A private lawsuit alleging the illegal sale of unlicensed securities and securities fraud was recently filed against the promoters of a highly successful initial coin offering, as well as other persons, in a state court in California. This legal action comes shortly after the Securities and Exchange Commission warned that ICOs could involve the offer and sale of securities subject to registration requirements that are not appropriately registered or exempt. Separately, the Commodity Futures Trading Commission filed and settled charges against a swap dealer, alleging that the firm failed to disclose certain price information in a manner precisely required by regulation prior to swap entry and afterwards. As a result, the following matters are covered in this week’s edition of Bridging the Weeks:

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The lawsuit – filed in a California state court – was initiated by Andrew Baker who claimed to have purchased 5,000 tokens (known as “Tezzies”) that he believed he would receive when the Tezos network was launched. Tezzies are intended to be the virtual currency underpinning the Tezos blockchain.

According to an Executive Summary on its website (click here to access), Tezos is designed to be a decentralized blockchain like Bitcoin and Ethereum, but with a different form of governance that establishes “rules for stakeholders to approve of protocol upgrades that are automatically deployed on the network,” rather than vest effective control in centralized core development teams or miners. Tezzies would allegedly allow their holders to facilitate payments or execute smart contracts on the Tezos blockchain network, as well as control the rules of the Tezos network by voting on system upgrades.

Among other allegations, the lawsuit claims that the initiation of the Tezos network has been delayed beyond its promised launch date in September 2017, and that funds collected by the Tezos Foundation – created to manage funds raised through the ICO – “are not being allocated as ICO participants were told they were.”

Defendants named in the lawsuit include Dynamic Ledger Solutions, Inc., which the lawsuit alleges owns all of the Tezos-related intellectual property; Arthur and Kathleen Breitman, who the lawsuit claims are the owners and controllers of DLS; the Tezos Foundation; and Johann Gevers, who the lawsuit says is the president of the Tezos Foundation. According to the lawsuit, the Tezos ICO raised US $232 million. No response pleadings have yet been filed in this action.

Mr. Baker seeks restitution and disgorgement of ill-gotten gains, rescission of his purchase of Tezzies, damages and fees.

Background and My View: Earlier this year, the Securities and Exchange Commission published a Report of Investigation which concluded that digital tokens issued by an entity for the purpose of raising funds for projects – even if using distributed ledger or blockchain technology – may be securities under federal law. If so, the securities must be registered with the Commission or eligible for an exemption from registration requirements. Moreover, the SEC concluded that any person offering trading facilities like an exchange for digital tokens that are securities must be registered as a national securities exchange or be exempt from such registration requirement. (Click here to access the Commission’s Report; click here to access an analysis of this SEC report in the article “SEC Warns That Digital Tokens May Be Securities” in an August 3, 2017 Advisory published by Katten Muchin Rosenman LLP.)

Many international regulators have similarly issued guidance warning that digital tokens issued as part of ICOs may be securities and subject to local laws and regulations. Some regulators have formally banned ICOs in their jurisdictions. (Click here for background in the article “SEC Files Lawsuit Against Companies and Backer for Purportedly Fake Initial Coin Offerings” in the October 1, 2017 edition of Bridging the Week.)

Last week the SEC warned of potentially unlawful promotion of ICOs by celebrities (click here to access SEC statement). Moreover, the SEC previously announced the formation of a cyber unit and a retail strategy task force within its Division of Enforcement that will concentrate on violations of law involving ICOs and distributed ledger technology, among other cyber-related misconduct.

Separately, in July, the Commodity Futures Trading Commission approved LedgerX as a swap execution facility and derivatives clearing organization for fully collateralized swaps based on cryptocurrencies. (Click here for details in the article “LedgerX Approved by CFTC as First Derivatives Clearing Organization for Fully Collateralized Swap Contracts Potentially Settling in Bitcoin” in the July 30, 2017 edition of Bridging the Week.)

Last month, CME Group announced plans to launch a futures contract by year-end based on a proprietary index derived from pricing data of four Bitcoin exchanges (click here to access the CME Group announcement), while the CBOE Futures Exchange previously indicated it would also list cash-settled Bitcoin futures contracts before year-end or early 2018. CBOE’s futures contract would reference prices provided by Gemini Trust Company, a digital asset exchange (click here to access the CBOE announcement). TeraExchange has listed a cash-settled Bitcoin-referenced swaps contract (Bitcoin non-deliverable forwards) since 2014 (click here for background).

Other than having their activities subject to requirements of the Financial Crimes Enforcement Network of the US Department of Treasury, no spot virtual currency exchange is subject to functional federal regulation. (Click here for background on FinCEN’s requirements.) However, the CFTC recently commenced an enforcement action against two related defendants for running a Ponzi scheme related to spot Bitcoin (not futures or swaps based on Bitcoin). In its lawsuit, the CFTC relied on a 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 for background in the article “CFTC Files Charges Alleging Bitcoin Ponzi Scheme Not Involving Derivatives” in the September 24, 2017 edition of Bridging the Week.) One of the defendants in the CFTC lawsuit recently filed an answer to the Commission’s complaint arguing that the CFTC had no authority to bring its lawsuit because virtual currencies are not commodities, but rather property or currency. (Click here to access the Admissions and Denials of Nicholas Gelfman.)

Previously, the SEC declined to approve a rule change proposed by the Bats BZX Exchange to authorize the listing of shares of the Winklevoss Bitcoin Trust, an exchange-traded product, whose pricing would have been derived from the prices of Bitcoin traded on the Gemini exchange. Among other things, the SEC said that, for an exchange-traded product to be approved, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity, and significant markets must be regulated. Since those conditions did not exist for Bitcoin, said the SEC, BZX’s application was denied. (Click here for details.) The SEC subsequently agreed to reconsider its denial (click here for details).

The regulatory framework governing digital tokens and currencies is evolving and even their legal nature is uncertain. As I have noted in an earlier commentary, the characteristic of some digital tokens is similar to those of chameleon-like security futures products that may change their essential nature over time.

Some digital tokens have always been, like Bitcoin, a pure cryptocurrency, which are rewarded to miners for their own services and, from their initiation, principally serve as a store of value, unit of account or a medium of exchange. Other digital tokens may have initially been offered and sold as, and designed with a purpose similar to, a security but morph over time into a medium of exchange. Ether, for example, the digital token associated with Ethereum, appears to be a digital token with these characteristics after it emerged from a crowd sale in 2014, where participants purchased what effectively were shares in the Ethereum development project; today, Ether is mostly regarded as a virtual currency. Currently, almost no one would consider Ether a security despite its characteristics at birth.

As a result, because of the ambiguous nature of digital tokens in the first instance and their sometime changing purpose over time, it is imperative that potential jurisdictional issues between the CFTC and SEC be sorted out sooner, not later, in order to ensure smooth development of cryptocurrencies and the blockchain. A first step would be for the CFTC and SEC to address potential overlaps voluntarily; a second, may be amendments to law.

According to the Commission, these requirements obligated the firm prior to entering into an uncleared swap as well as on an ongoing basis afterwards, to disclose to its counterparty the mid-market mark of the swap. This price is not permitted to include “any amounts for profit, credit reserve, hedging, funding liquidity, or any other costs or adjustments.” (Click here to access CFTC Rule 23.431.) The purpose of this requirement, said the Commission, is to permit a counterparty to see its swap dealer’s mark-up on its swaps.

However, said the Commission, Cargill’s methodology for calculating mid-market marks purportedly hid the precise revenue the firm would derive from each swap transaction as they were based on amortizing the firm’s estimated revenue on the swap. Moreover, said the Commission, the methodology was used despite concerns raised by some employees to senior managers. As a result, the CFTC charged Cargill with failure to compute mid-market marks correctly, failure to report correct mid-market marks to a swap data repository, as also required, and failure to supervise.

Cargill neither admitted nor denied any of the CFTC’s findings or conclusions in its offer of settlement to avoid an administrative proceeding. In a separate statement, Cargill said that it “is committed to providing its customers with the timely and accurate information they need to make risk management decisions with confidence” (click here to access the firm’s full statement).

Cargill was provisionally registered as a swap dealer in 2013.

Legal Weeds and My View: In August 2015, the CFTC settled charges against another swap dealer for failure to adequately supervise the swaps trading activities of one of its former swap traders who allegedly entered into 30 unauthorized bilateral swaps transactions with one customer from January through July 2013. (Click here for access to the relevant CFTC Order.)

The swap dealer was charged by the Commission with a violation of its Rule 23.602(a), which requires all swap dealers and major swap participants to “establish and maintain a system to supervise, and shall diligently supervise, all activities relating to its business performed by its partners, members, officers, employees, and agents” (emphasis added). (Click here to access the full text of CFTC Rule 23.602(a).) This provision sets forth different standards than the CFTC’s traditional supervisory requirements for all registrants under its Rule 166.3 – the rule under which Cargill was charged for failure to supervise. Rule 166.3 does not expressly require registrants to establish a supervisory system. It solely states that “[e]ach Commission registrant, except an associated person who has no supervisory duties, must diligently supervise the handling by its partners, officers, employees and agents … of all commodity interest accounts carried, operated, advised or introduced by the registrant, and all other activities of its partners, officers, employees and agents … relating to its business as a Commission registrant.” (Click here to access the full text of CFTC Rule 166.3.)

However, in its August 2015 settlement order regarding the other swap dealer, the Commission noted that Rule 166.3 “has been interpreted as requiring that, in order to establish a failure to supervise, the Commission establish that a registrant’s supervisory system was generally inadequate or that the registrant failed to perform its supervisory duties diligently” (emphasis added). Although it seems reasonable that a registrant should have robust policies and procedures to help ensure it can adequately oversee its business, this is different from saying the rule requires a supervisory system when, by its plain language, it does not. This incongruity seems profound now that Rule 23.602(a), in fact, imposes such an express requirement.

It is unclear why the CFTC relied on Rule 166.3 (which applies to all registrants, including swap dealers) in its action against Cargill as opposed to Rule 23.602 (which applies specifically to swap dealers). Moreover, it seems odd in any case for the CFTC to charge Cargill with failure to have an adequate supervisory system “to perform its supervisory duties diligently” when the Commission alleged that some of the firm’s senior managers were proactively involved in the decision to use the mid-market mark methodology to which the CFTC objected. A supervisor choosing a wrong course of conduct does not constitute a failure to supervise by his/her employee; it’s solely a violation of the substantive provisions of law and rules that makes the conduct incorrect.

Wash Sales and Money Passes

In one disciplinary action, the Business Conduct Committee of the Chicago Mercantile Exchange ordered Franco Della Pina, a non-member, to pay a US $100,000 fine; disgorge US $25,200; pay restitution of almost US $2,000 and be permanently barred from directly or indirectly accessing CME Group markets for allegedly engaging in multiple round turn E-mini S&P futures transactions to transfer equity from a friend’s account and another non-member's account he controlled to his own personal account. The relevant trades purportedly occurred from July through November 2014. The BCC also charged Mr. Della Pina with trading E-mini S&P futures contracts between two accounts with common beneficial ownership over which he had control from April 2014 through July 2014, and failing to appear before exchange staff for an interview in connection with an investigation.

Unrelatedly, Intl FCStone Financial Inc., a member, agreed to settle two disciplinary actions brought by the New York Mercantile Exchange alleging that it had engaged in wash sales between accounts with the same beneficial owner on “numerous” occasions between August 2015 and December 2015, and December 2014 and July 2016. NYMEX also brought and settled disciplinary actions again Darris Gustin, the FCStone trader who purportedly executed the transactions from August 2015 to December 2015, and Bruce Benefiel, the FCStone trader who was charged with executing the transactions from December 2014 to July 2016.

Intl FCStone also settled for failing to supervise its two traders, in connection with the relevant transactions. NYMEX claimed the firm “failed to provide instruction or guidance to its trader[s]” regarding the exchange’s prohibition against wash sales. Intl FCStone agreed to pay a combined fine of US $160,000 to resolve the two disciplinary actions while Mr. Benefiel consented to pay a sanction of US $20,000 and Mr. Gustin agreed to remit a US $15,000 fine. Both individuals also consented to temporary all CME Group access suspensions.

Disruptive Trading

Separately, NYMEX charged Sudeep Moniz with violating its prohibition against engaging in disruptive practices when he allegedly used layered orders on one side of the market to execute resting orders on the other side of the market from January 8, 2015, through February 27, 2015, and October 28, 2015, through November 8, 2015. The exchange claimed that Mr. Moniz cancelled his layered orders after his other-side-of-the-market orders were executed. NYMEX also charged Mr. Moniz with failing to “fully answer” all questions by exchange staff during an interview conducted during their investigation. Mr. Moniz agreed to pay a fine of US $150,000 and be subject to a six-week all CME Group access suspension to resolve NYMEX’s disciplinary action.

Independently, Wen-Hsiung Cheng, a non-member, was ordered by the Chicago Board of Trade’s Business Conduct Committee to pay a fine of US $50,000 and serve a five-year all CME Group exchange access suspension for entering pre-open orders in the Oats and Rough Rice futures markets from October 1, 2014, through May 20, 2015, that were not made “in good faith for the purpose of executing bona fide transactions." The BCC claimed these orders caused “fluctuations” in the publicly displayed indicative opening price, and that Mr. Cheng also failed to appear for interviews with exchange staff during their investigation.

Trading Against Customers

Elliot Reichel, a member, agreed to pay a fine of US $10,000 and restitution of US $11,500 and serve a four-moth all CME Group exchanges trading suspension for purportedly disadvantaging customer orders through various means on multiple occasions in open outcry trading on the CME between March and June 2015 and on June 23, 2017. Among other things, CME claimed that Mr. Reichel failed to execute a customer order at the best trade price available in the market on two occasions; on “one or more occasions,” changed an executed price to one more favorable to opposite traders; and on one occasion, traded in the same future product for a profit prior to filling an order for the same product for a customer.

Audit Trail Requirements

Finally Tower Research Capital, LLC was charged by each of the CME Group exchanges with not ensuring that its Tag 50 user identification registrations were accurate at all times from November 1, 2013, through December 27, 2013, and that its traders used a unique user ID, as required in connection with their access to Globex. Each of the CME Group exchanges claimed that this failure delayed their investigation into trading activities of the firm’s employees. (In settling these disciplinary actions with Tower, however, each of the CME Group exchanges acknowledged the firm’s “subsequent cooperation” to help them complete their investigation.) Tower was also charged with failing to supervise the activity of certain of its traders. To resolve these matters, Tower agreed to pay a total fine of US $150,000 and disgorge profits of US $162,000.

Compliance Weeds: CME Group requires that Tag 50 user IDs be registered with it for (1) individual members, (2) employees of individual members, (3) employees or contractors of clearing members, CME or CBOT equity member firms, or NYMEX or COMEX Rule 106.J. member firms; (4) any party receiving preferential fees pursuant to a program offered by any CME Group exchange; or (5) any market participant otherwise designated by an Exchange. Moreover such registrations are required to be maintained current and accurate at all times. (Click here to access CME Group Rule 576 and here to access CME Group Market Regulation Advisory Notice RA1610-5: “CME Globex Tag 50 ID Requirements,” dated October 7, 2016.)

User ID requirements and other obligations for electronic orders vary from exchange to exchange and the devil is in the detail. Clearing members and relevant traders should periodically review prevailing requirements and ensure their systems and processes accurately capture required audit trail information and that user ID information is promptly updated as required. (Click here for background in the article “ICE Futures Issues Guidance Regarding Identification Requirements for Orders Placed Through Its Electronic Trading System” in the February 26, 2017 edition of Bridging the Week.)

More briefly:

For further information:

Backers of Tezos Initial Coin Offering Named in Prospective Class Action Litigation:

Block Trading Authorized in Agricultural Products by CME Group:

CFTC Staff Grants No-Action Relief Related to Swaps Execution:

CME Group Exchanges CME Group Exchanges Bring Disciplinary Actions Charging Wash Sales, Money Passes and Disruptive Trading and Failure to Follow Audit Trail Requirements:

Department of Treasury Think Tank Questions Safety of a Central Counterparty in CDS Market:

HK Regulators Impose Requirements to Mitigate Internet Trading Hacking Risk:

International Food and Agriculture Company Agrees to Pay US $10 Million Fine to CFTC to Resolve Charges Related to Swaps Pricing Disclosure:

New CFTC Commissioner Criticizes Rush to Finalize and Implement Dodd Frank Rules:

SEC Charges Day-Trader With Unauthorized Trading in Illicitly Accessed Accounts to Inflate Market Prices:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of November 11, 2017. 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.

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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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