Federal Court Ruling Recognizes CFTC Jurisdiction over Cryptocurrencies as Commodities
The U.S. Commodity Futures Trading Commission (CFTC) scored a victory in its effort to assert jurisdiction over portions of the cryptocurrency and initial coin offering (ICO) markets last week, as a federal district judge preliminarily enjoined defendants charged with operating a fraudulent virtual currency scheme in violation of the Commodity Exchange Act (CEA).
The lawsuit, CFTC v. McDonnell, et al., is one of the first of its kind, with the CFTC alleging that the defendants fraudulently induced customers to send money and virtual currencies “in exchange for purported virtual currency trading advice” and for virtual currency trades on their behalf. Upon receiving payments from several customers, the defendants allegedly cut off communications and kept the funds. At the heart of the CFTC’s claim is the assertion that cryptocurrencies are commodities subject to the jurisdiction of the CFTC, a proposition the court accepted when, on March 6, it granted an injunction in favor of the CFTC. Judge Weinstein found that the CFTC had shown a reasonable likelihood that the defendants would continue to violate the CEA” and that the law permitted the CFTC to assert “jurisdiction over fraud that does not directly involve the sale of futures or derivative contracts” but instead involves the underlying of futures or derivatives contracts. The ruling lends further credence to the recent expansion of regulatory authority over cryptocurrency and related products and services.
Background on Cryptocurrency Regulation
Cryptocurrency has increasingly attracted the attention of regulators. In 2013, the U.S. Financial Crimes Enforcement Network (FinCEN) issued interpretive guidance stating that certain federal registration requirements can apply to parties engaged in virtual currency–related services. The CFTC’s first foray into the realm of cryptocurrency regulation came in September 2015, when it resolved charges against Coinflip Inc. for facilitating options transactions involving cryptocurrencies, which the agency classified as commodities. The Securities and Exchange Commission (SEC) followed suit, including by issuing a July 2017 ruling that classified ICOs as securities and warned offerors of applicable registration requirements. In December 2017, SEC Chairman Jay Clayton issued a statement emphasizing that the SEC’s purview extends to digital tokens when they fall within the definition of “securities” under federal securities law, which is likely when issuers emphasize the possibility for appreciation in value and encourage the development of secondary markets for them.
The start of 2018 has seen regulators race to respond to the rise of cryptocurrency in the public eye in late 2017. On January 19, 2018, the CFTC and the SEC issued a joint statement reinforcing their commitment to enforcing securities and commodities laws with respect to cryptocurrencies and related products. The day before, the CFTC filed two separate cryptocurrency-related lawsuits, including the suit in the Eastern District of New York against CabbageTech Corp. (doing business as Coin Drop Markets) and its owner, Patrick K. McDonnell.
Overview of CFTC v. McDonnell, et al.
In its January 2018 complaint, the agency alleged that McDonnell and his company, operating as Coin Drop Markets, solicited customers to pay for exclusive virtual currency trading advice from purported experts. In addition, McDonnell allegedly advertised access to cryptocurrency day traders in exchange for a subscription fee. After attracting several customers, McDonnell and Coin Drop Markets disappeared from the internet, erasing their online presence and dropping off communications with customers. In its complaint, the CFTC asserted that the alleged fraud constituted a violation of the CEA and CFTC regulations and sought an injunction, in addition to civil monetary penalties and ancillary relief.
On March 6, U.S. District Judge Jack B. Weinstein denied McDonnell’s motion to dismiss and granted the CFTC’s request for a preliminary injunction. “CFTC may exercise its enforcement power over fraud related to virtual currencies sold in interstate commerce,” Judge Weinstein wrote. In characterizing cryptocurrency as a commodity, Judge Weinstein cited the CFTC’s definition of the term as “all . . . goods and articles . . . in which contracts for future delivery are presently or in the future dealt in.” The CFTC has previously specified that it views its jurisdiction as extending both to all matters involving virtual currency derivatives and to fraud and manipulation in cryptocurrency spot markets (seemingly including for cryptocurrencies that have not yet developed futures markets).
Implications of Regulating Cryptocurrency as a Commodity
Judge Weinstein’s ruling reinforces the CFTC’s authority to regulate cryptocurrencies as commodities. Notably, the CFTC has indicated that it generally does not view its authority as extending to individual transactions involving virtual currency in the absence of fraud or manipulation. Rather, the agency has argued that it is authorized to regulate derivatives contracts involving cryptocurrency, as well as instances of fraud in interstate commerce in the actual underlying cryptocurrency.
As the CFTC exercises jurisdiction over cryptocurrency-related products and services, companies operating in that space will need to be aware of the restrictions stemming from the CEA. The law’s restrictions extend to price manipulation—including “pump-and-dump schemes”—in cryptocurrency, pre-arranged and wash trading in exchange-traded swap or futures contracts, futures and option contracts and swaps on cryptocurrencies traded on a platform not registered with the CFTC, and other schemes marketed to retail customers (subject to the jurisdictional nexus requirement set forth in Sec. 2(i) of the CEA).
Beyond CFTC jurisdiction over fraud involving cryptocurrency, advisors seeking to trade derivatives on cryptocurrencies (futures, options, forwards, and swaps) in collective investment vehicles (commodity pools) or for separately managed accounts must be aware of potential commodity pool operator (CPO) and/or commodity trading advisor (CTA) CFTC registration and National Futures Association (NFA) membership requirements. Personnel who solicit investments in a commodity pool or a separately managed account for which the advisor is acting in its capacity as a registered CPO or CTA may be required to register with the NFA as an associated person (AP) of the CPO or CTA. AP registration often brings with it the requirement to take and pass the Series 3 examination, the NFA examination administered by the Financial Industry Regulatory Authority. Exemptions from CPO and CTA registration may be available depending on the advisor’s circumstances, with some exemptions requiring a notice filing with the NFA to claim the exemption. Exemptions from AP registration or alternatives to taking and passing the Series 3 examination may also be available depending on circumstance.
While Judge Weinstein’s wide-ranging decision reinforces the CFTC’s claims of jurisdiction in this field, it also recognizes the potential for other government agencies to regulate cryptocurrency. In testimony provided before the Senate Banking Committee on February 6, 2018, CFTC Chairman J. Christopher Giancarlo stated, “the CFTC’s enforcement jurisdiction over virtual currencies is not exclusive,” citing cooperation with the SEC, FinCEN, the Internal Revenue Service, and state banking regulators.
In the short term, the CFTC moves forward in its case against McDonnell and Coin Drop Markets equipped with an order that requires the defendants to refrain from further fraudulent conduct, preserve its books and records, and provide expedited discovery to the CFTC. An evidentiary hearing will follow in June, at which the court will consider converting the preliminary injunction into a final injunction.
The CFTC is simultaneously engaged in additional litigation in the Eastern District of New York, as it has filed suit against a U.K.-based commodity pool operator and its owner. That suit focuses on allegations that the defendants deceived customers into investing over US$1 million in cryptocurrency options and falsely claimed that a hacking prevented them from engaging in the promised trades.
Meanwhile, companies should expect increasing regulatory efforts by other agencies, including FinCEN and the SEC. Until Congress passes legislation clarifying the allocation of regulatory responsibility, all three—the CFTC, SEC, and FinCEN—are likely to push forward in requiring registration and policies in compliance with the various statutes governing commodities, securities, and banking service providers.
How Dechert Can Assist
The increasing use of cryptocurrencies and other digital assets has given rise to complex legal issues relating to regulatory status (including requirements to register as broker-dealers, commodity pool operators, commodity trading advisors, investment advisers, investment companies, securities exchanges and money service businesses), compliance (including valuation, custody and reporting), corporate law (such as maintain shareholder records), securities transactions (including initial coin offerings and M&A transactions), fund formation, the launch of ETFs and derivatives, venture capital, taxation, anti-money laundering, litigation and regulatory enforcement.
Dechert offers sophisticated and knowledgeable legal counsel to clients navigating this rapidly evolving space. At the heart of Dechert’s cryptocurrency and blockchain practice is a deep understanding of the technologies that drive blockchain and related developments in distributive computing networks. In addition, Dechert is distinctive among leading law firms in this area by bridging the financial service regulation and new financial technology to find solutions for our clients.