Bridging the Week by Gary DeWaal

Bridging the Week by Gary DeWaal: January 22 to 26, and 29, 2018 (Fake Coins, Real News; “It Depends” Advice; Market Abuse; Insider Information)

AML and Bribery    Audits and Accounting    Bitcoin Ecosystem    Bridging the Week    Cryptosecurities    Culture and Ethics    Customer Protection    Fraud and Anti-Fraud    Legal Weeds    Managed Money    Market Abuse    Trade Practices (including Disruptive Trading)   
Published Date: January 28, 2018

It was real and not fake news last week when the Commodity Futures Trading Commission finally disclosed the details of an enforcement action alleging a fraudulent scheme involving a fake virtual currency that was reported to have been filed two weeks ago but for which no details were made public at the time. Separately, the chairman of the Securities and Exchange Commission warned lawyers about providing “it depends” advice to issuers of digital tokens in initial coin offerings that are very likely securities. Additionally, the chairs of the SEC and the CFTC said that it might be appropriate to re-evaluate whether the current regulatory framework governing currency transactions fits neatly for transactions involving cryptocurrencies. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • CFTC Sues Unregistered Company and Promoters of Fake Virtual Coin for Alleged Fraud and Operating Purported Ponzi Scheme (includes Legal Weeds);
  • SEC Chairman Warns Lawyers Providing “It Depends” Advice on ICOs (includes Legal Weeds);
  • UK Financial Services Regulator Sanctions E-Brokerage Company GBP 1.049 Million for Inadequate Systems to Monitor Potential Market Abuses;
  • Former Employees of Major Accounting Firm Subject to Criminal Charges and SEC Enforcement Action for Alleged Scheme to Use Nonpublic PCAOB Information for Firm’s Benefit (includes Culture and Ethics); and more.

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  • CFTC Sues Unregistered Company and Promoters of Fake Virtual Coin for Alleged Fraud and Operating Purported Ponzi Scheme: The Commodity Futures Trading Commission disclosed that it filed an enforcement action on January 16 against My Big Coin Pay, Inc. (MBCP), and two persons closely involved with the company – Randall Crater and Mark Gillespie – for allegedly engaging in a virtual currency scheme that misappropriated approximately US $6 million from 28 or more persons from at least January 2014 through this month. The CFTC’s complaint, filed in a federal court in Massachusetts, also named other persons as “relief defendants” who purportedly received customer funds obtained through the misappropriation.

The CFTC charged the defendants with making false or misleading statements to customers and fraud.

According to the CFTC, as part of their fraudulent scheme, the defendants offered a virtual currency coin named “My Big Coin” (MBC) for sale to customers. The CFTC claimed that the defendants falsely represented, among other misrepresentations, that their coin was actively traded on multiple currency exchanges, including the MBC Exchange; issued daily statements regarding the daily trading price of MBC; and issued written statements saying that MBC was backed by gold, was a global currency that could be used to send money worldwide, and could be used anywhere that MasterCard was accepted. None of these claims were true, charged the CFTC.

The CFTC also claimed that some MBCP customers were paid out using funds of other customers “in the manner of a ‘Ponzi scheme’.”

The CFTC sought and obtained a temporary order from the court freezing all of the defendants’ and relief defendants’ assets and prohibiting them from destroying or altering any records. The CFTC seeks an injunction, disgorgement, restitution, and fines against the defendants.

On January 18, the CFTC brought two enforcement actions in a federal court in Brooklyn, New York, alleging fraud and other law violations in connection with cryptocurrency investment schemes. At the time, the media reported that a third action was pending, but the details of the action – this enforcement action against MBCP  were not disclosed until last week. (Click here for details in the article “CFTC Files Two Enforcement Actions Charging Fraud in Connection with Cryptocurrencies Sale Schemes” in the January 21, 2018 edition of Bridging the Week.)

Legal Weeds: To prosecute alleged miscreants fraudulently offering or selling spot virtual currencies, the CFTC continues to use the full force of its authority under a provision of law (enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act) and a 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.” To employ this provision, the CFTC is not required to allege fraud in connection with transactions involving swaps or a commodity for future delivery on or subject to the rules of any registered entity. Solely alleging fraud in connection with a spot commodity in transactions in interstate commerce is sufficient. (Click here to access CEA Section 6(c)(1), 7 U.S.C. §9(1) and here for CFTC Rule 180.1(a).)

The CFTC has previously employed these legal provisions in response to a wide variety of fact patterns from their first use in the JP Morgan “London Whale” episode to allegations of illegal off-exchange metals transactions, insider trading, claims of more traditional manipulation and attempted manipulation (without endeavoring to show an artificial price) and allegations of spoofing. (Click here for background in the article “International Bank and Affiliates Settle Two CFTC Enforcement Actions for Alleged Benchmarks Manipulation” in the June 5, 2016 edition of Bridging the Week.)

In September 2017, the CFTC brought an enforcement action against a company and its chief executive officer and head trader for running a purported Ponzi scheme related to Bitcoin. That case remains pending. (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.)

  • SEC Chairman Warns Lawyers Providing “It Depends” Advice on ICOs: In a speech last week before the Securities Regulation Institute, Securities and Exchange Commission Chairman Jay Clayton cautioned lawyers who may not be instructing clients that digital tokens issued as part of initial coin offerings are securities and subject to possible registration requirements, when the digital tokens are “likely” securities under applicable law standards. According to Mr. Clayton, such lawyers provide their clients “it depends” advice, when there is little doubt regarding the nature of the product offered during an ICO. In response, Mr. Clayton warned he has instructed SEC personnel “to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.”

​Mr. Clayton additionally noted that the SEC would be "looking closely" at public companies that change their name to reference the blockchain – such as to "Blockchain-R-Us" – when the company has no demonstrable track record of utilizing the blockchain for business purposes. Mr. Clayton indicated that the SEC would be looking at such companies' public disclosures to see if such firms are complying with applicable securities laws.

Separately, Mr. Clayton and J. Christopher Giancarlo, Chairman of the Commodity Futures Trading Commission, penned an Opinion published in The Wall Street Journal on January 24, where they acknowledged that a “key issue” they are reflecting upon is “whether our historical approach to the regulation of currency-transactions is appropriate for the cryptocurrency markets.” As a result, said the two chairpersons, “[w]e would support policy efforts to revisit these frameworks and ensure they are effective for the digital era.”

Currently, in the US, the SEC has broad oversight over all securities and securities markets, while the CFTC does not have direct authority over exchanges that transact in virtual currencies, unless the facilities offer trading in swaps or futures involving such products, or financing to retail clients in connection with their purchases of virtual currencies that do not result in actual delivery within 28 days. Exchanges or persons holding virtual currencies are likely subject to requirements by the Financial Enforcement Network of the Department of Treasury, and money transmitter obligations or other requirements by many states. (Click here for a broad overview of the US regulatory environment involving cryptocurrencies in the CFTC’s January 4, 2018 “Backgrounder on Oversight and Approach to Virtual Currency Futures.”)

In other unrelated material developments involving cryptocurrencies:

  • Cboe BZX Withdraws Requests to Trade Bitcoin ETFs: Cboe BZX Exchange, Inc. withdrew a number of pending proposed rule changes filed with the Securities and Exchange Commission in December 2017 to list exchange-traded funds that principally intended to trade Bitcoin futures. (Click here for a sample withdrawal notice.) This follows issuance two weeks ago of a letter by the SEC’s Division of Investment Management to two industry organizations indicating that no SEC registered funds were likely to be approved for trading virtual currencies or virtual currency futures contracts until questions regarding custody, liquidity and potential manipulation were satisfactorily answered. (Click here for further details in the article “SEC Not Feeling Groovy About Cryptocurrencies – Tells Registered Investment Funds: Slow Down, You Move Too Fast” in the January 22, 2018 edition of Bridging the Week.)
  • Korean Regulator Imposes New Requirements on Banks for Cryptocurrency Exchange Transactions: The Korean Financial Services Commission imposed new requirements on banks facilitating trading on cryptocurrency exchanges in Korea. Under the new requirements, users who engage in cryptocurrency transactions must have a bank account in their real name at the same bank where the cryptocurrency exchange they utilize maintains an account. Moreover, banks must apply enhanced due diligence in evaluating transactions with cryptocurrency exchanges and the exchanges must provide users’ identification information to their banks, upon request. (Click here for a copy of the FSC announcement.) Additionally, eight Korean cryptocurrency exchanges were fined by the Korean Communications Commission for not complying with data protection requirements for their users and required to meet their obligations within 30 days (click here for background).

Legal Weeds: On July 25, 2017 the SEC published a Report of Investigation concluding 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, such 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.)

The SEC’s Report followed an investigation by the SEC’s Division of Enforcement which concluded that digital tokens offered and sold during April and May 2016 by DAO, an unincorporated virtual organization created by UG, a German corporation, were securities subject to the SEC’s registration requirements. According to the SEC, investors purchased DAO tokens through transactions on the Ethereum Blockchain in exchange for approximately 12 million Ether (“ETH,” a virtual currency) that was valued at approximately US $150 million at the time.

The SEC based its conclusion that the DAO tokens were securities on the four-part test articulated in a landmark 1946 US Supreme Court decision, SEC v. W.J. Howey (click here to access). There, the Supreme Court ruled that a security includes an “investment contract” and an investment contract constitutes an (1) investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived solely from the entrepreneurial or managerial efforts of others. Applying this test to the DAO entity and DAO tokens, the SEC concluded that purchasers of DAO tokens (1) invested money in the form of ETH (2) to invest in a common enterprise, the DAO entity, (3) with an expectation of profits from projects. Moreover, the Commission concluded (4) that since the profits of the DAO enterprise would be derived significantly from the managerial efforts of, its co‑founders and the DAO’s curators, the fourth prong of the Howey test was also satisfied. A few years prior to Howey, the US Supreme Court in SEC v. C.M. Joiner Leasing Corp. (click here to access), indicated that, in assessing whether an investment in oil leases constituted a security, investors' expectation of profits could be satisfied by the expected capital appreciation of their investment through the development efforts of others – not only by their anticipated receipt of earnings.

More recently, the SEC filed and simultaneously resolved an enforcement proceeding against Munchee Inc., for conducting an initial digital coin offering of "MUN" digital tokens that it claimed constituted the unregistered offer or sale of securities. Munchee agreed to cease and desist from its violations to settle this matter. Although Munchee in its "White Paper" described the utility benefits of possessing MUNs in promotional materials and other marketing efforts (e.g., the more MUNs a person held, the more MUNs it would receive for writing restaurant reviews), the principal benefit of holding MUNs was the potential for appreciation of their value through Munchee’s entrepreneurial efforts. As a result, concluded the SEC, MUN tokens were securities and Munchee’s offer and sale of MUN tokens without filing a registration statement with it (absent a bona fide exemption) was illegal. (Click here for further details in the article “Non-Registered Cryptocurrency Based on Munchee Food App Fails to Satisfy SEC’s Appetite for Non-Security” in the December 17, 2017 edition of Bridging the Week.)

  • UK Financial Services Regulator Sanctions E-Brokerage Company GBP 1.049 Million for Inadequate Systems to Monitor Potential Market Abuses: Interactive Brokers (UK) Limited was assessed a fine of GBP 1.049 million by the UK Financial Conduct Authority for allegedly not having adequate risk management systems to detect and report potential instances of market abuse, and for not filing certain reports of suspicious transactions, as required.

According to FCA, from February 2014 to February 2015, IBUK relied on a global compliance team at its US affiliate to conduct post trade surveillance. However, claimed the FCA, IBUK did not adequately oversee the US team’s reviews and ensure that the US team had “adequate guidance or effective training.” FCA also claimed that IBUK did not file suspicious transaction reports in connection with profitable trading close in time to a regulatory new service announcement on three occasions.

In its representations, IBUK said that it “incorporated into its systems the expertise of a substantial and well-trained team of compliance officers engaged by its US sister company to identify market abuse from a US And UK perspective.” In response, the FCA noted that, “[w]hile it was not unacceptable… for IBUK to outsource the review, this did not discharge IBUK’s own obligations in relation to the review process.”

  • Former Employees of Major Accounting Firm Subject to Criminal Charges and SEC Enforcement Action for Alleged Scheme to Use Nonpublic PCAOB Information for Firm’s Benefit: Five persons were criminally charged in a federal court in New York City with engaging in a scheme to illicitly obtain confidential information from the PCAOB to benefit KPMG, a major accounting firm.

The individuals were charged with orchestrating a scheme to help KPMG obtain nonpublic information from the PCAOB regarding which prior KPMG audits of public companies the PCAOB would review during upcoming inspections in order to assess KPMG’s performance. The individuals were David Britt, Cynthia Holder, David Middendorf, Jeffrey Wada and Thomas Whittle. A sixth individual, Brian Sweet, pleaded guilty to conspiracy and wire fraud charges in connection with the same matter. All individuals, except for Mr. Wada, were KPMG employees during relevant times, while Ms. Holder, Mr. Sweet and Mr. Wada were all PCAOB employees at relevant times; Ms. Holder and Mr. Sweet joined KPMG as employees from the PCAOB.

All the individuals were also the subjects of administrative proceedings filed by the Securities and Exchange Commission. Mr. Sweet simultaneously settled his SEC action.

Generally, in both the criminal and civil matters, KPMG employees were claimed to have solicited and obtained the confidential information from the named former PCAOB employees either while they were employed at the PCAOB and/or after they joined KPMG.

According to the US Attorney’s Office in New York City, which oversaw the criminal charges, KPMG “fared poorly” in its PCAOB inspections for 2013 and 2014 and the SEC formally met with KPMG in 2016 “in light of concerns about audit quality work from KPMG’s poor PCAOB inspection results.” As a result, claimed the indictment against the non-settling defendants, KPMG engaged in numerous efforts to improve its PCAOB audit evaluations, including hiring former PCAOB employees. With information regarding pending audits, KPMG purportedly reviewed and augmented relevant work papers to help avoid deficiency findings by the PCAOB.

When the defendants’ actions began being investigated, Ms. Holder, Mr. Sweet and Mr. Wada attempted to cover up their activities, charged the indictment.

If convicted of charges against them, each of the non-settling defendants could be imprisoned up to 65 or 85 years as well as being subject to fines and other penalties. In connection with his SEC settlement, Mr. Sweet agreed never to appear or practice before the SEC as an accountant, among other penalties.

The PCAOB, established as part of the Sarbanes-Oxley Act of 2002, oversees the audits of public companies to protect the interests of investors, among other purposes. It endeavors to achieve its purpose through inspection of audits of public companies by registered public accounting firms. A version of PCAOB's inspection results is made public. (Click here for background regarding the PCAOB; click here for background regarding Sarbanes-Oxley.)

Culture and Ethics: As most know, for many years, I was Group General Counsel of Fimat and Newedge, a subsidiary of Société Générale. I will allow my effectiveness to be assessed by others, but one thing of which I am very proud is my nearly evangelical ongoing exhortation of the necessity of all employees to abide by a simple universal base-line compliance standard – the grandmother test. Quite simply, if you would be embarrassed to sit at breakfast with your 90-year-old grandmother when she picks up her morning tabloid and reads about your conduct on the front page, don’t do it! It’s simple, but it works – at least for most grandmothers!

More Briefly:

  • Former Options Trader Pleads Guilty to Trading Futures Options to Disguise Trading Losses and Causing Collapse of Employer: Thomas Lindstrom, a former futures trader, pleaded guilty to engaging in trading activities involving 10-year Treasury futures options to hide losses of over US $13.7 million that led to the financial collapse of his employer, Rock Capital Market LLC in 2015. Mr. Lindstrom was charged criminally for his conduct and sued by the CFTC in September 2016. Mr. Lindstrom likely faces between 97 and 121 months’ prison time for his offenses. (Click here for background in the article “Trader Indicted for Exploiting Minimum Futures Pricing Convention to Hide Trading Losses and Causing Firm Collapse; CFTC Also Files Civil Charges” in the December 2, 2016 edition of Bridging the Week.)
  • CBOT Member Settles Exchange Charges He Disrupted Indicative Opening Price Through Illegitimate Bids and Offers: Richard Whitlow, a member of the Chicago Board of Trade, settled charges with the exchange that, between December 1, 2015, and August 15, 2016, he engaged in pre-open activities constituting disruptive trading practices in violation of the relevant rule (click here to access CBOT Rule 575.A). According to CBOT, during the relevant time, Mr. Whitlow entered bids and offers in various grains and oilseeds futures contracts during pre-open sessions without the intent to execute bona fide transactions. This activity, said the CBOT, caused “fluctuations” in the indicative opening price. Mr. Whitlow agreed to pay a US $25,000 fine and serve a 30-business-day all CME Group exchanges trading suspension to resolve his charges.
  • HK Securities Regulator Bans Individual Registrant Six Months for Emailing Himself Customer Information Prior to Departing Employer: The Securities and Futures Commission of Hong Kong banned Chan Wai Nun from all industry activity for six months for transferring to himself client personal data from his employer, prior to leaving his employer and joining another firm. The transfer of client personal data from his former employer violated the firm’s internal policies and relevant law.

For further information:

CBOT Member Settles Exchange Charges He Disrupted Indicative Opening Price Through Illegitimate Bids and Offers:

CFTC Sues Unregistered Company and Promoters of Fake Virtual Coin for Alleged Fraud and Operating Purported Ponzi Scheme:

Former Employees of Major Accounting Firm Subject to Criminal Charges and SEC Enforcement Action for Alleged Scheme to Use Nonpublic PCAOB Information for Firm’s Benefit:

Former Options Trader Pleads Guilty to Trading Futures Options to Disguise Trading Losses and Cause Collapse of Employer:

HK Securities Regulator Bans Individual Registrant Six Months for Emailing Himself Customer Information Prior to Departing Employer:

SEC Chairman Warns Lawyers Providing “It Depends” Advice on ICOs:

UK Financial Services Regulator Sanctions E-Brokerage Company GBP 1.049 Million for Inadequate Systems to Monitor Potential Market Abuses:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of January 27, 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.

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