Bridging the Week by Gary DeWaal


Bridging the Week by Gary DeWaal: July 22 – 26, and July 29, 2019 (Or ≠ And; Actual Delivery = Real Delivery; Gaming Tokens ≠ Securities; Ain’t Broke = Working)

AML and Bribery    Bridging the Week    Canadian Regulation (sans Capital and Liquidity)    Fraud and Anti-Fraud    Introducing Brokers    Investment Advisers    Legal Weeds    Manipulation    My View    Registration    Regulation MAR    Trade Practices (including Disruptive Trading)   
Published Date: July 28, 2019

A federal appellate court in California issued a decision effectively ratifying the Commodity Futures Trading Commission’s expansive view of its authority to bring enforcement actions addressing a diverse range of purported wrongdoings under the Dodd-Frank Wall Street Reform and Consumer Protection Act provision prohibiting any manipulative or deceptive device or contrivance. In the same decision, the court also agreed with the CFTC that another Dodd-Frank section that excludes from CFTC licensing requirements the sale of leveraged or margined commodities to retail customers where actual delivery occurs within 28 days mandates meaningful, real delivery to such persons or their agents where they have effective control. This interpretation may have a significant impact on virtual currency and other businesses that offer or seek to offer leveraged or margined financial products from the United States or to US persons. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • Federal Appeals Court Upholds Expansive CFTC View of Prohibition Against Manipulative or Deceptive Device and Restrictive View of Actual Delivery (includes My View); 
  • SEC Corp Fin Says Gaming Digital Token Not Marketed as an Investment Is Not a Security (includes Legal Weeds); 
  • Securities Exchanges Sanction Trading Member for Reg MAR Violation Even Though No Problematic Trading (includes My View)and more.

Video Version:

Article Version

Briefly:

  • Federal Appeals Court Upholds Expansive CFTC View of Prohibition Against Manipulative or Deceptive Device and Restrictive View of Actual Delivery: A federal appeals court in California reversed the dismissal by a federal district court of the Commodity Futures Trading Commission’s September 2017 lawsuit against Monex Credit Company and related companies and principals (collectively, “Monex”). Monex is a retail precious metals dealer based in Newport Beach, California.

The CFTC had alleged that Monex enabled retail investors to purchase precious metals on margin without actual delivery through its proprietary Atlas Program and not on a licensed exchange or board of trade as required by law, acted as a futures commission merchant without registration and committed fraud in connection with solicitation activities by making false or misleading statements. 

In response, Monex moved to dismiss the CFTC’s lawsuit. The firm claimed that its Atlas Program was not prohibited because it entailed the actual delivery of precious metals in financed transactions to retail persons even though it retained control over the commodities because of the financing. Monex also asserted that the statutory prohibition relied on by the CFTC against the firm – prohibiting “any manipulative or deceptive device or contrivance” – required that it commit fraud that affected or potentially affected a market or constituted fraud‑based manipulation. Monex argued that since the CFTC solely alleged that it engaged in fraud without reference to any market or manipulation, the agency’s charges against it could not stand.

The federal district court agreed with Monex’s legal analysis and dismissed the CFTC’s lawsuit in May 2018. (Click here for details 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.) However, the United States Court of Appeals for the Ninth Circuit reversed the district court’s appeal. 

First, the appeals court held that the district court misapplied the relevant law that exempts leveraged or margined retail commodity transactions from CFTC oversight where “actual delivery [occurs] within 28 days.” (Click here to access 7 U.S.C. § 2(c)(2)(D)(ii)(III)(aa).) Monex had claimed that this provision would have no practical meaning if “actual delivery” required possession or control by a customer “because such a reading would clash with ‘margin,’ which means ‘cash or collateral required to be paid to a securities broker by an investor to protect the broker against losses from securities bought on credit’.” However, the appeals court rejected this view, writing that “[w]hile permitting customers to obtain significant control over or possession of metals might be practically difficult here, that fact does not displace the statute’s plain meaning.”

Second, the court of appeals concluded that the word “or” in the phrase “manipulative or deceptive device or contrivance” (emphasis added) must be read disjunctively and not conjunctively. (Click here to access the relevant legal provision, 7 U.S.C. § 9(1).) As a result, the CFTC has authority to bring enforcement actions where it alleges either a manipulative device or a deceptive device or contrivance; it need not charge both, said the appeals court. It is not relevant, as Monex argued, that the applicable law (i.e., the Commodity Exchange Act) contains express stand-alone anti-fraud provisions. According to the appeals court, the relevant law’s “overlap with other provisions is minimal, and partial redundancy hardly justifies displacing otherwise clear text.”

In reversing the district court’s dismissal of the CFTC’s enforcement action, the court of appeals presumed all facts alleged by the Commission were true. The CFTC will still have to prove its allegations in any subsequent trial. In addition to other remedies, the CFTC seeks an injunction against Monex, a fine and to have the company pay restitution to its customers.

My View: The Ninth Circuit’s decision is a significant victory for the CFTC as it effectively, materially validates its sweeping view of a section of law enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This provision makes it illegal:

for any person, directly or indirectly, to use or employ, or attempt to use or employ, in connection with any swap, or a contract of sale of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity, any manipulative or deceptive device or contrivance, in contravention of such rules and regulations as the Commission shall promulgate.

Pursuant to this law, the CFTC adopted CFTC Rule 180.1 (click here to access).

The CFTC has already utilized these measures as the wild junkyard dog of its enforcement arsenal without any apparent leash or restraint as it sees them as “broad, catch-all provision[s] reaching fraud in all its forms.” (Click here for background at 75 Fed. Reg. 67,657, 67,658 (CFTC November 3, 2010).) The CFTC has employed these sections in a wide range of enforcement actions stemming from its first use in 2013 in the JP Morgan “London Whale” episode to subsequent allegations of illegal off-exchange metals transactions, claims of more traditional manipulation of wheat, allegations of spoofing, and claims of insider trading, among other offenses. Most recently, the CFTC used these provisions to bring an enforcement action against a former portfolio manager for mismarking valuations of certain interest rate swaps from approximately June 2016 through April 2017 in order to increase his performance bonus. (Click here for details in the article “Ex-Portfolio Manager for Commodity Pool Operator and Investment Advisor Charged by CFTC and SEC for Mismarking Swaps for Bigger Bonus” in the July 21, 2019 edition of Bridging the Week.) 

The Monex case is likely to embolden the CFTC in its aggressive and creative use of these provisions of law.

Similarly, rejection by the court of appeals of the district court’s holding that the CFTC’s view of “actual delivery” undercuts Congress’s apparent effort to accommodate leveraged and financed commodity transactions in Dodd-Frank may also embolden the CFTC to prosecute more US-based unlicensed trading platforms or dealers that offer persons anywhere leveraged or margined commodities of any kind (including virtual currencies) and non-US-based persons that offer such leveraged or margined products to US retail persons (technically, non-eligible contract participants; click here for the definition of an ECP at 7 U.S.C. §1a(18.). This decision could also jump-start the CFTC’s finalization of its 2017-proposed interpretation on “actual delivery” involving virtual currencies that has been dormant for some time. (Click here for background 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.)

  • SEC Corp Fin Says Gaming Digital Token Not Marketed as an Investment Is Not a Security: The Securities and Exchange Commission’s Division of Corporation Finance issued a no-action letter saying that a digital token designed to facilitate access to a multitude of online video games would not be required to be registered as an equity security. The NAL was sought by Pocketful of Quarters, Inc. (“POQ”) for its proposed “Quarters” digital coin. POQ proposes to introduce a Quarters platform that will leverage blockchain technology to allow gamers to access participating video games and enter hosted tournaments using Quarters which it hopes to evolve into a universal gaming token.

Corp Fin said it granted no action to POQ because, among other reasons, (1) the firm would not use funds from Quarters’ sales to develop the Quarters’ platform; (2) Quarters would be immediately usable at the time they were sold; (3) gamers would only be able to transfer Quarters for gameplay to developers with approved accounts or to POQ for tournaments; (4) only developers and so-called “influencers” with approved accounts would be permitted to exchange Quarters for the virtual currency “ether” at predetermined exchange rates; (5) Quarters would be made available in unlimited quantities and fixed prices; and (6) the purchase price of Quarters would correspond to the market price of accessing and playing participating games. Additionally, Quarters would be marketed solely for consumptive use and as a means to access participating games and not as an investment.

According to the NAL request submitted by POQ, Quarters would not constitute investment contracts (and thus securities) under the 1946 Supreme Court decision SEC v. W.J. Howey principally because “no gamer will be motivated to purchase Quarters by any reasonable expectation of profits.” The SEC has previously relied on the four prongs derived from Howey to assess whether a digital asset might be an investment contract and be subject to applicable securities laws (i.e., (1) an investment of money, (2) in a common enterprise with (3) the expectation of profits (4) from the efforts of a promoter or third party. (Click here to access the Howey decision.)

In other legal and regulatory developments involving cryptoassets:

  • Bitfinex and Related Companies Answer NY AG Complaint by Saying They Had No NY Connections: Bitfinex and related companies moved to dismiss the special proceeding commenced by the New York Attorney General against them earlier this year, claiming that respondents have for some time barred US persons from their platforms, and thus they are not subject to lawsuit by the NY AG. In April 2019, the NY AG obtained an ex parte order from a New York State court prohibiting companies associated with Bitfinex as well as the stablecoin “tether” from accessing, loaning or encumbering in any way US dollar reserves supporting tether digital coins. Respondents also argued that tether is neither a security nor a commodity and thus not subject to the relevant law the NY AG sued them under. (Click here to access the most relevant provision of the Martin Act. Click here to access background regarding the NY AG’s initial lawsuit in the article “NY Attorney General Sues Stablecoin Issuer and Related Companies for Purportedly Misusing Tethered Fiat Currency Without Customer Disclosure” in the April 28, 2019 edition of Bridging the Week.)
     
  • IRS Begins Reminding Individual Taxpayers of Virtual Currency Transactions Tax Payment Obligations: The United States Internal Revenue Service announced it has begun sending letters to US taxpayers reminding them of their obligations to pay taxes on transactions involving virtual currencies no matter where they occurred  The IRS noted that persons who do not meet their tax obligations on a timely basis could be subject to fines and interest in addition to the amount of taxes, and in some circumstances, criminal prosecution. The IRS previously has said that virtual currencies are property for federal tax purposes (click here for IRS Notice 2014-21).
     
  • NYS DFS Moves Licensing of Virtual Currency Companies to New Research and Innovation Division: The New York Department of Financial Services placed the former division responsible for licensing and overseeing virtual currency activity in a new division named the “Research and Innovation Division.” The new section will also “assess new efforts to use technology to address financial exclusion, identify and protect consumer data rights, and encourage innovation in the financial services marketplace.” Presumably, the new section will oversee issuance of so-called BitLicenses. (Click here for background regarding New York’s BitLicense requirements in the article “New York BitLicense Regulations Virtually Certain to Significantly Impact Transactions in Virtual Currencies” in a July 8, 2015 Advisory by Katten Muchin Rosenman, LLP.)
     
  • Facebook Agrees to Settle FTC and SEC Charges Related to Data Use for US $5.1 Billion Fine: Less than two months after announcing its Libra stablecoin initiative, Facebook settled charges filed on behalf of the Federal Trading Commission and by the Securities and Exchange Commission related to customers’ data use. In a legal action brought by the Consumer Protection Branch of the US Department of Justice on behalf of the FTC, Facebook agreed to pay a US $5 billion fine and to establish a privacy committee of the firm’s board of directors and appoint compliance officers to be responsible for Facebook’s privacy program in order to settle charges that, at various times from 2010 through at least June 2018, it misled users regarding their ability to control the use of their personal information through privacy settings. Separately, Facebook agreed to pay US $100 million to the SEC for advising investors from 2016 until mid-March 2018 about the potential misuse of users’ personal data in theoretical terms, when in fact Facebook was aware since December 2015 that a company employee had improperly sold information of “tens of millions of Facebook users” to Cambridge Analytics, a data analytics firm. Facebook made such disclosures, charged the SEC, in risk factor disclosures in public filings. (Click here for background regarding Facebook's Libra initiative in the My View commentary t0 the article "Global AML Standards Setter Says Countries Should Require Virtual Asset Service Providers to Obtain and Transmit Certain Information Regarding Senders and Recipients for All Virtual Asset Transfers” in the June 23, 2019 edition of Bridging the Week.)
     
  • Canada OSC Settles With Company for Trading Cryptosecurities Without License: CoinLaunch Corp., a Canadian company, agreed to pay a fine, disgorgement and costs totaling over CAN $50,000 to the Ontario Securities Commission for facilitating the offering of two digital tokens that constituted securities, without registering to be in the business of trading securities, as required, under Ontario law. CoinLaunch marketed itself as a crypto consulting firm that helped companies administer digital token offerings, solicit potential investors, and find seed funding for token offerings.

Legal Weeds: Previously, SEC Corp Fin indicated it would not recommend an enforcement action against TurnKey Jet, Inc. for issuing a digital asset to facilitate sales of air charter services without registering the token as a security under applicable law. 

According to a description written by TurnKey, the digital token, as proposed, would effectively be a stablecoin offered in increments of US $1 that would effectuate easier payment for air charter services by potential users to air charter providers (including potentially TurnKey) and intermediary brokers. All transactions would occur solely among subscribers to TurnKey’s membership program utilizing the firm’s fully developed permissioned blockchain and smart contract technology. Proceeds from token purchases would be deposited in escrow accounts maintained at FDIC-insured US banks. Users could only use the tokens on the TurnKey network. Tokens might be repurchased by TurnKey but ordinarily only at a discount to face value. As a result, tokens might also be bought and sold among members, but there would be no “incentive to buy from other Token holders at a premium above one dollar per Token.” 

TurnKey itself would solely fund the development and operation of its network (and not use any proceeds from token purchases) and would charge membership fees to users, providers and brokers. TurnKey would market the tokens for their functionality and not as an investment. (Click here for a copy of the TurnKey NAL.)

Although both the TurnKey and Quarters NALs provide valuable insight into what indicia Corp Fin believes would not cause an asset to be regarded as an investment contract (and thus a security), the fact patterns hardly seem controversial. A stablecoin backed 100 percent by one fiat currency and an admission token to arcade games do not seem the type of instruments that could reasonably be deemed securities. Although SEC staff is applauded for taking small steps to not interfere with the development of legitimate blockchain technology applications, some bigger, more insightful leaps are hopefully forthcoming.

  • Securities Exchanges Sanction Trading Member for Reg MAR Violation Even Though No Problematic Trading: Clear Street Markets, LLC, a registered broker-dealer, settled disciplinary actions by six US securities exchanges, including Cboe BZX and EDGX (collectively, the “Exchanges”), for solely utilizing a manual surveillance system for a large period from November 1, 2012, to January 31, 2016, to satisfy its obligation under the Securities and Exchange Commission’s Market Access Regulation that became effective in 2011. Under this rule, broker-dealers with market access must maintain a system of risk management controls and supervisory procedures to control the risks associated with market access, including their own and other market members’ financial circumstances, the integrity of trading on the markets and the stability of the financial system. (Click here to access SEC Rule 15c3-5.)

According to the Exchanges, during a large period of the relevant time period, Clear Street’s business involved making markets in over 3,000 securities and handling over five to 20 million orders daily as part of its proprietary activities. However, during much of the relevant time, the firm solely conducted manual reviews to detect market disruption activities such as marking the close, layering or spoofing Although the Exchanges expressly acknowledged that during the period “there were no instances” of the identified abuses occurring, they claimed the firm’s manual surveillance was not a reasonable system of risk management controls and supervisory procedures. 

The Exchanges also claimed that the firm’s automated system to prevent the accidental entry of erroneous orders was also not satisfactory because the thresholds of one of its electronic quoting systems was set too high. There was no charge against Clear Street that at any time it actually entered too many erroneous orders. The firm agreed to pay a fine of US $60,000 to resolve the Exchanges’ disciplinary action.

My View: Implicit to the old adage “if it ain’t broke, don’t fix it” is that "it" worked. It is troubling enough when regulators routinely challenge the reasonableness of procedures when something goes wrong; it is puzzling, at a minimum, to read of this challenge when apparently everything went right.

More Briefly:

  • Former Trader with Two Separate Investment Banks Settles CFTC Spoofing Charges and Enters Into Cooperation Agreement: The Commodity Futures Trading Commission settled enforcement actions against Corey Flaum, a former precious metals traders accused of engaging in spoofing. 

According to the CFTC, Mr. Flaum engaged in his illicit conduct from approximately 2007 through approximately 2016, a period of time when he was employed by Bear, Stearns & Co. Inc and Scotia Capital (USA) Inc. He would typically place at least one non-aggressive order on one side of a market intending it to be executed, and one or more very visible non-aggressive orders on the other side of the market with the intent to cancel such orders. He entered his spoofing orders with the intent to facilitate the execution of his genuine orders, claimed the CFTC. 

As part of the settlement, the CFTC reserved a determination of sanctions against Mr. Flaum who agreed to fully cooperate with the CFTC’s Division of Enforcement. 

Separately, Mr. Flaum pleaded guilty to attempted commodities price manipulation in connection with the same conduct for which he was charged by the CFTC; his sentencing is scheduled for October 29, 2019. 

  • CFTC Staff and FinCEN Agree That Certain Registered Introducing Brokers Need Not Comply With Customer Identification Program Requirements: The Commodity Futures Trading Commission issued interpretive guidance relieving introducing brokers that do not have customers or introduce customer accounts to futures commission merchants from having to conduct due diligence and obtain certain information and documents to satisfy customer information program and beneficial ownership obligations imposed by the Commission and the Financial Crimes Enforcement Network of the US Department of Treasury. (Click here to access CFTC Rule 42.2.) Typically such IBs are those commonly referred to as “voice brokers” that enter orders for transacting parties that already have independently established relationships with FCMs.
     
  • SEC OCIE Notes Investment Advisors Sometimes Weak in Disclosing Prior Disciplinary History of Supervised Employees: The Securities and Exchange Commission’s Office of Inspections and Examinations observed that one half of disclosure-related deficiencies spotted at investment advisors involved failures to provide adequate information regarding disciplinary events of supervised employees or the advisor itself. Also, OCIE observed that some firms did not have a compliance program containing procedures that addressed the risks of employing persons with disciplinary histories, and did not adequately document in writing expectations of supervisors in hiring and overseeing employees with disciplinary histories. OCIE recommended that investment advisors enhance their written policies and procedures related to the hiring of persons with disciplinary histories and the supervision of such persons once employed.
     
  • Two International Firms Cited by Ontario Securities Regulator for Operating Online Trading Platforms Accessible by Province’s Residents Without Registration: Ava Trade Ltd and International Capital Markets Pty Ltd. (“ICM”) – non-Canada-based companies – were sanctioned collectively over CAN $10 million by the Ontario Securities Commission for selling derivatives to Ontario-based investors through online trading platforms without being appropriately registered or providing investors prospectuses. The products included contracts for differences based on underlying assets, including virtual currencies, foreign exchange, equities and commodities. In connection with ICM, the OSC found that the firm’s interactions with Ontario investors were inadvertent as they were not expressly targeted, while OSC “found no evidence o[f] dishonest conduct” by AVA. 
     
  • CFTC, SEC and Other Federal Agencies’ Inspection Units Highlight Top Management and Performance Challenges of Financial Sector Regulatory Organizations: The Council of Inspectors General on Financial Oversight identified enhancing oversight of financial institution cybersecurity as a principal risk in its 2019 annual report of key challenges in identifying and responding to emerging threats to US financial stability. Other challenges identified by this organization of inspection heads of nine federal financial regulatory agencies included managing and securing information technology at regulatory organizations; sharing threat information; ensuring readiness for new crises; strengthening agency governance; managing human capital; and improving contract and grant management. 

According to the report, 31.5 percent of all permanent federal employees will be eligible for retirement in 2022. As a result, agencies need to plan for succession and identify potential leadership gaps. CIGFO identified material deficiencies among federal financial regulators in addressing potential leadership and institutional knowledge issues in the coming years. 

CIGFO was created under the Dodd-Frank Wall Street Reform and Consumer Protection Act to oversee the Financial Stability Oversight Council and to suggest measures to enhance financial oversight. The organization includes inspection heads of the Commodity Futures Trading Commission and the Securities and Exchange Commission and seven other federal financial regulators.

For further information

Bitfinex and Related Companies Answer NY AG Complaint by Saying They Had No NY Connections:

Canada OSC Settles With Company for Trading Cryptosecurities Without License:
https://www.osc.gov.on.ca/documents/en/Proceedings-RAD/rad_20190724_coinlaunch.pdf
https://www.osc.gov.on.ca/documents/en/Proceedings-SET/set_20190719_coinlaunch.pdf

CFTC, SEC and Other Federal Agencies’ Inspection Units Highlight Top Management and Performance Challenges of Financial Sector Regulatory Organizations:
https://www.sec.gov/files/CIGFO-TMPC-Report-July-2019.pdf

CFTC Staff and FinCEN Agree That Certain Registered Introducing Brokers Need Not Comply With Customer Identification Program Requirements:
https://www.cftc.gov/csl/19-18/download

Facebook Agrees to Settle FTC and SEC Charges Related to Data Privacy for US $5.1 Billion Fine:

Federal Appeals Court Upholds Expansive CFTC View of Prohibition Against Manipulative or Deceptive Device and Restrictive View of Actual Delivery:
http://cdn.ca9.uscourts.gov/datastore/opinions/2019/07/25/18-55815.pdf

Former Trader with Two Separate Investment Banks Settles CFTC Spoofing Charges and Enters Into Cooperation Agreement:
https://www.cftc.gov/media/2301/enfCoreyD.Flaumorder072519/download
https://www.justice.gov/opa/pr/former-precious-metals-trader-pleads-guilty-attempted-commodities-price-manipulation

IRS Begins Reminding Individual Taxpayers of Virtual Currency Transactions Tax Payment Obligations:
https://www.irs.gov/newsroom/irs-has-begun-sending-letters-to-virtual-currency-owners-advising-them-to-pay-back-taxes-file-amended-returns-part-of-agencys-larger-efforts

NYS DFS Moves Licensing of Virtual Currency Companies to New Research and Innovation Division:
https://www.dfs.ny.gov/reports_and_publications/press_releases/pr1907231

SEC Corp Fin Says Gaming Digital Token Not Marketed as an Investment Is Not a Security:
https://www.sec.gov/corpfin/pocketful-quarters-inc-072519-2a1

SEC OCIE Notes Investment Advisors Sometimes Weak in Disclosing Prior Disciplinary History of Supervised Employees:
https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20Supervision%20Initiative.pdf

Securities Exchanges Sanction Trading Member for Reg MAR Violation Even Though No Problematic Trading:
http://cdn.cboe.com/resources/regulation/disciplinary/2012/WBPX-Cboe-EDGX-2012035187507-AWC_Redacted.pdf
http://cdn.cboe.com/resources/regulation/disciplinary/2012/WBPX-Cboe-BZX-2012035187504-AWC_Redacted.pdf

Two International Firms Cited by Ontario Securities Regulator for Operating Online Trading Platforms Accessible by Province’s Residents Without Registration:

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


© 2019 Katten Muchin Rosenman and Gary DeWaal. All Rights Reserved.