A federal court in Brooklyn, New York, denied the request of Patrick McDonnell to reconsider its March 2018 rejection of his motion to dismiss a CFTC enforcement action on the ground that the agency has no authority to exercise enforcement authority over an alleged fraud involving cryptocurrencies, absent a claim of fraud-based market manipulation.

Earlier this year, the CFTC sued CabbageTech, Corp., a NY corporation, and Mr. McDonnell, its owner and controller, for unlawfully soliciting customers to send money and virtual currencies for virtual currency trading advice and for the discretionary trading of virtual currencies by Mr. McDonnell. However, alleged the CFTC, the defendants did not provide the promised services and misappropriated their customers’ funds. (Click here for background 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.)

In response, Mr. McDonnell filed a motion to dismiss. The Brooklyn federal court denied Mr. McDonnell’s motion, holding that virtual currencies are commodities under applicable law, and that the CFTC has standing to sue persons for fraud in connection with spot sales of virtual currencies, even where such sales do not involve derivatives contracts. (Click here for background in the article “A Court, Treasury and the SEC Confirm Substantial Overlap in US Jurisdiction of Cryptocurrencies” in the March 8, 2018 edition of Between Bridges.)

In his motion for reconsideration, Mr. McDonnell asked the court to reconsider its earlier decision based on the outcome of a May 1, 2018, federal court decision in California involving Monex Deposit Company and other defendants. There, the court held that the CFTC cannot use the prohibition against persons engaging in any manipulative or deceptive device or contrivance in connection with the sale of any commodity in interstate commerce enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act to prosecute acts of purported fraud except in instances of fraud‑based market manipulation. (Click here for background 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.)

In ruling against Mr. McDonnell in response to his request for reconsideration, the Brooklyn federal court noted that it “fully considered Monex and reaches a different conclusion.” The court said that, in its view, the relevant statute supported the CFTC’s standing to bring its enforcement action. (Click here to access the relevant statute, 7 U.S.C. § 9(1).)

The Monex decision was recently appealed by the CFTC to a federal appellate court in California. (Click here for background in the article “Expedited Federal Court of Appeals Review of Monex Lower Court Decision Requested by CFTC” in the June 24, 2018 edition of Bridging the Week.)

In other unrelated matters involving digital assets last week: 

  • Ag Committee Considers Oversight of Digital Assets: The House Committee on Agriculture held a hearing on the regulatory challenges of digital assets. Among the persons testifying was Gary Gensler, former Chairman of the Commodity Futures Trading Commission and currently a senior lecturer at the MIT Sloan School of Management. Mr. Gensler argued that there “may be a gap” in the current oversight of cryptocurrencies that are not securities. He said that the current regulatory oversight provided through state money transmission regulations “is not satisfactory,” and, as a result, “Congress may wish to consider providing the CFTC – or another agency – with general authorities to write rules for [spot digital asset] markets, including possibly requiring registration for trading on crypto exchanges solely dealing in cryptocurrencies.” Separately, Daniel Gorfine, the CFTC’s Chief Innovation Officer and Director of LabCFTC, suggested that current regulatory frameworks might have to be reconsidered to accommodate digital assets because current frameworks center on “intermediaries or gatekeepers that manage the access to our markets or financial services activity.” However, new innovators are endeavoring to “disintermediate or substantially transform models” to enhance efficiencies. In response, Mr. Gorfine said that “regulators will need to proactively identify how rules and regulations conform or will need to change.” Last week, the House Financial Services Committee also held a hearing on digital currencies and the future of money.  
  • Financial Stability Board Announces Framework to Oversee Digital Asset Markets: The Financial Stability Board announced a framework to monitor the financial stability implications of developments regarding digital assets. Although the FSB concluded that “crypto assets do not pose a material risk to global financial stability at this time,” it said there was a need for formally monitoring “in light of the speed of market developments.” The FSB said it will initially monitor metrics related to market capitalization, prices, and derivatives; banks’ exposure to digital assets; and correlations of volatility and between major digital assets and other asset classes such as gold, currencies and equities. Established in 2009, the FSB is an international organization comprising representatives of national authorities responsible for financial stability in material international financial centers that monitors and makes recommendations about the global financial system. (Click here for background on the FSB.)  
  • NY Department of Financial Service Grants Another BitLicense: The New York Department of Financial Services granted BitPay, Inc. a virtual currency license (“BitLicense”) to offer clearing and settlement services to merchants that accept or issue payments in Bitcoin. DFS has now approved 10 firms for a BitLicense or a virtual currency charter. (Click here for background on NY’s Bitlicense in the article “NYDFS Issues BitLicense Framework for Regulating Virtual Currency Firm” in the June 5, 2015 edition of Bridging the Week.)  
  • Jersey Issues Guidance on ICO Application Process: The Jersey Financial Services Commission issued guidance regarding the application process for persons seeking to conduct initial coin offerings from Jersey. The requirements will apply to all ICO issuers whether the digital asset may be considered a security under Jersey law. Among other things, the issuer must be incorporated as a Jersey company; prepare and submit to the Jersey Financial Services Commission an information memorandum (which could be a so-called “White Paper”) which complies with certain content requirements; ensure that any promotional material is “clear, fair, and not misleading; receive consent from the JFSC before undertaking any activity; and be subject to an ongoing audit requirement.

Legal Weeds and My View: A federal court in Massachusetts is expected to rule soon on a motion to dismiss made by Randall Crater and the relief defendants in the CFTC’s My Big Coin Pay, Inc. enforcement action filed earlier this year. In that action, the CFTC claimed that My Big Coin Pay, Inc. and two persons closely involved with the company – Mr. Crater and Mark Gillespie – allegedly engaged in a virtual currency scheme that misappropriated approximately US $6 million from 28 or more persons from at least January 2014 through January 2018. (Click herefor background in the article “CFTC Sues Unregistered Company and Promoters of Fake Virtual Coin for Alleged Fraud and Operating Purported Ponzi Scheme” in the January 28, 2018 edition of Bridging the Week.)

Mr. Crater and the relief defendants argued in papers to support a motion to dismiss that the CFTC has no jurisdiction to bring its enforcement action alleging fraud in connection with the sale of the virtual currency known as “My Big Coin,” because the virtual currency was not a commodity under applicable law. This is because, said the defendants, the virtual currency was neither a good nor an article, or a service, right or interest in which contracts for future delivery are dealt in. If My Big Coin is not a commodity, the CFTC had no authority to prosecute a fraud case against them under applicable law, claimed the defendants.

Moreover, the defendants argued that the CFTC had no standing to bring a general anti-fraud case against them relying on a fraud-based manipulation prohibition adopted as part of Dodd-Frank. As did Mr. McDonnell in his request for reconsideration in CabbageTech, the defendants in My Big Pay Coin relied on the recent federal court decision involving Monex in proposing such an argument.

The CFTC disagreed with the defendants’ legal arguments, claiming that My Big Coin was either a good or an article, and thus a commodity, or in the alternative was a category of virtual currencies, like Bitcoin, for which futures contracts currently exist. In addition, the CFTC said that the reasoning of the Monex decision was flawed. The Commission claimed that the relevant law prohibited “any manipulative or deceptive device” (emphasis added), and rejected the federal court’s view that “or” should be read as “and.” (Click here to access certain defendants memorandum of law in support of their motion to dismiss; click here to access the CFTC’s response.)

In my view, a cryptocurrency may exist solely in digital form, but it is still likely a good or an article. As the New York Court of Appeals recently held in connection with source code, computer code stored on a computer takes up space on a drive. As a result, it must be physical in nature. (Click here for background on this NY Appeals Court decision in the article “Investment Bank Ex-Employee’s Conviction Upheld for Theft of High-Frequency Trading Algorithmic Code” in the May 6, 2018 edition of Bridging the Week.)