The Commodity Futures Trading Commission (CFTC) recently garnered attention by announcing two settled cases involving the agency’s jurisdiction over bitcoin products.1 While these cases focused attention on the status of digital currency as a “commodity” under the jurisdiction of the CFTC,2 they also serve as an important reminder that, under the Commodity Exchange Act (CEA), CFTC rules and enforcement powers are extensive and cover derivative instruments, “swaps”3 and “futures,” on nearly anything, from a physical “thing” such as wheat or coal, to a virtual financial instrument. This means that the possibility of CFTC regulatory requirements and regulatory risk now needs to be considered when dealing with a product or transaction that has characteristics of a derivative instrument. This realization may be particularly jarring for those who are newly subject to CFTC regulation due to the expansion of its jurisdiction to cover swaps as a result of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Simply put, the CFTC has jurisdiction over swaps and futures on commodities. Although every issue must be addressed on its specific facts, and the CFTC may take positions that may be successfully challenged, a quick recitation of five aspects of the statutory scheme provides a sense of how far the CFTC may claim that its jurisdiction can reach: 1) “Commodity” is defined in a somewhat circular fashion to include (with a couple of very specific exceptions)4 “all . . . goods and articles, and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.”5 1 On September 17, 2015, against Coinflip, the operator of an online trading platform that facilitated the trading of derivatives on bitcoin and other digital currencies, including U.S. dollar cash-settled options, for marketing bitcoin derivatives without being properly registered with the CFTC. In re Coinflip, Inc., Dkt. No. 15-29 (CFTC Sept. 17, 2015), available at: http://www.cftc.gov/ucm/groups/public/ @lrenforcementactions/documents/legalpleading/enfcoinfliprorder09172015.pdf. On September 24, 2015, the agency announced a settlement of charges against TeraExchange, a CFTC-registered Swaps Execution Facility (SEF), for allowing a digital currency swap trade that was both a “wash trade” and a “prearranged trade” in violation of U.S. law and regulations. In re TeraExchange LLC, Dkt. No. 15-33 (CFTC Sept. 24, 2015), available at: http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/ legalpleading/enfteraexchangeorder92415.pdf. 2 The CFTC treats digital currencies as commodities, but not as currencies, in the same category as precious metals. This treatment has a significant regulatory impact by taking digital currencies out from the so-called Treasury exemption, which exempts certain foreign currency products from CFTC regulation. See Sidley Update “CFTC Asserts Jurisdiction Over Bitcoin Derivatives,” available at http://www.sidley.com/en/news/10-15- 2015-derivatives-update. 3 Swaps based on single securities, narrow-based security indices and single loans are regulated by the Securities and Exchange Commission as security-based swaps and therefore are not subject to the CFTC’s jurisdiction. See https://www.sec.gov/spotlight/dodd-frank/derivatives.shtml. 4 Onions and motion picture box office receipts are the exceptions. 7 U.S.C. §1a(9). There is a history behind these seemingly random exceptions, but among regulatory implications, the import is that futures contracts based on onions or movie box office receipts are prohibited and unlawful. 5 7 U.S.C. §1a(9). SIDLEY UPDATE Page 2 2) A “futures contract” is not defined in the statute, and “swap” is very broadly defined.6 3) CFTC jurisdiction also reaches in certain respects what are called “retail commodity transactions,” 7 e.g., cash-settled precious metals transactions offered or sold to retail investors on a leveraged or margined basis, or financed by the counterparty. 4) CFTC jurisdiction includes “retail forex” transactions,8 e.g., cash-settled over-the-counter forex transactions offered or sold to retail investors. 5) Finally, CFTC jurisdiction over manipulation and, arguably, fraud is not limited to derivative transactions, but reaches any “contract of sale of any commodity in interstate commerce.”9 In other words, manipulation in respect of cash commodity transactions, including, for example, foreign currency spot and forward transactions, can trigger CFTC scrutiny and action. Moreover, Dodd-Frank grants the CFTC jurisdiction beyond the United States if swap activity is deemed to have a “direct and significant” connection with the U.S. activities or have a direct and significant effect on U.S. commerce. CFTC may assert jurisdiction over any transaction, wherever it may occur and whoever may be trading, that meets this test.10 Here are some of the key areas of regulation and enforcement risk, when trading products subject to CFTC regulation: • Certain derivatives (futures and certain specified swaps) are required to be traded on an appropriate platform, such as a Swap Execution Facility (SEF) or a Designated Contract Market (DCM) or otherwise in a manner consistent with CFTC requirements. Those requirements may constrain with whom and how you may enter a transaction. For instance, swaps generally cannot be traded other than on a DCM with anyone who is not an “eligible contract participant.”11 • Certain swap contracts are designated by the CFTC as being required to be cleared through a registered derivatives clearing organization.12 • Involvement in trading swaps may require registration with the CFTC. Providing swaps advice to others or being involved in placing the trades of others, may require CFTC registration, as may forming a pooled investment vehicle that trades swaps.13 There are thresholds for those “dealing” regularly in swaps that can also trigger swap dealer registration requirements.14 Providing a trading facility for entering into swaps 6 7 U.S.C. §1a(47). 7 7 U.S.C. §2(c)(2)(D). 8 7 U.S.C. §2(c)(2)(C). 9 7 U.S.C. §9(a)(2) (emphasis added). 10 See, e.g., 7 U.S.C. §2(i). 11 7 U.S.C. §2(e) 12 7 U.S.C. §§2(h). 13 See Sidley Updates “CFTC Issues Final Rules Amending CPO and CTA Registration and Compliance Obligations,” available at: http://www.sidley.com/en/news/cftc-issues-final-rules-amending-cpo-and-cta-registration-and-compliance-obligations-02-10-2012; “CPO/CTA Registration Requirements Under Dodd-Frank,” available at: http://www.sidley.com/en/news/cpocta-registration-requirements-under-dodd-frank- 09-07-2010. 14 7 U.S.C. §§6s, 1a(49). SIDLEY UPDATE Page 3 could also require registration.15 There is also a registration category of “major swap participant” that applies to persons who have a significant swaps exposure.16 • Reporting and recordkeeping requirements are applicable to most swaps, and margin is required to be posted for cleared swaps and may soon be required for many uncleared swaps.17 • U.S. law and regulations prohibit a transaction that can be characterized as a “wash trade,” an “accommodation trade,” or a “fictitious sale,” or a trade that “is used to cause any price to be reported, registered, or recorded that is not a true or bona fide price.”18 Any type of pre-arrangement or method of trading used to increase the likelihood that your trade will match with a particular other counterparty at a particular price on a trading platform may result in the CFTC asserting that you have run afoul of these requirements. For trades executed on a CFTC registered platform, there are specific prohibitions against (1) violating bids or offers, (2) intentional or reckless disregard for the orderly execution of transactions during a closing period, or (3) “spoofing,” which is defined in the statute as “bidding or offering with the intent to cancel the bid or offer before execution.”19 Both the exchanges and the CFTC – and criminal prosecutors – have been actively pursuing spoofing cases. They are carefully scrutinizing situations where it appears traders are entering trades and either cancelling them or entering them in a manner that suggests to the CFTC (or self-regulatory organization, such as the exchange) that the trader never intended for that bid or offer to be consummated. • The CEA broadly prohibits fraud and manipulation in connection with any transaction under the CFTC’s jurisdiction. The law allows the CFTC to investigate and bring fraud and manipulation cases for any cash commodity transaction in interstate commerce, as well as cases involving futures, swaps and commodity options.20 Moreover, the CEA specifically prohibits a person from entering into a swap transaction “knowing, or acting in reckless disregard for the fact, that its counterparty will use the swap as part of a” fraud against a third party.21 Generally speaking, the CFTC may seek to bring a fraud case based on reckless as well as intentional conduct. • As mentioned above, the CFTC has broad anti-manipulation authority, not just for derivatives markets, but also in the “cash” markets. Indeed, the agency often looks for indications of trading in one market that it thinks is designed to manipulate or create artificial prices in the other market. Again, the CFTC can bring a case based on recklessness at least in some cases; in such cases after the passage of Dodd-Frank, it no longer needs to prove actual intent. The CFTC can also bring cases for attempted manipulation, which requires only proof of an intent to manipulate and an act taken in furtherance of the intended conduct.22 15 7 U.S.C. §1a(50). 16 7 U.S.C. §1a(33). The CFTC’s website lists only two registrants in this category as of March 2013. 17 See Sidley Updates “Margin Requirements for Uncleared Swaps Continue to Take Form: Prudential Regulators and CFTC Re-Propose Similar Rules,” available at: http://www.sidley.com/news/11-12-14-derivatives-update; “Prudential Regulators Re-Propose Rules for Mandatory Margining of Uncleared Swaps; Similar CFTC Re-Proposal Anticipated Shortly,” available at: http://www.sidley.com/en/news/09-15-14-derivatives-update. 18 7 U.S.C. §6c(a)(1)(2). 19 7 U.S.C. §6c(a)(5). 20 7 U.S.C. §9. 21 7 U.S.C. §6c(a)(7). 22 7 U.S.C. §9. SIDLEY UPDATE Page 4 In most cases under the CEA and CFTC rules, persons can be civilly charged with being aiders or abettors, and can face principal-agent liability (or for “controlling” the person who engaged in the conduct) for any of the violations of law that the CFTC oversees.23 And, with regard to fraud and manipulation in particular, egregious cases may well draw scrutiny from local or federal criminal prosecutors. The CFTC can impose substantial monetary penalties, often ranging into the millions of dollars. Besides substantial civil monetary penalties, the CFTC may seek cease-and-desist orders or injunctions against further misconduct, disgorgement of profits and/or restitution to injured parties, and registration, trading bans and suspensions. Unlike the Securities and Exchange Commission, the CFTC can actually suspend or ban nonregistrants from trading in derivatives markets it regulates.24 What all of this means is that care must be taken when dealing in a form of transaction that could be a “future,” “swap,” other derivative, or even a “retail commodity transaction.” The enactment of Dodd-Frank and the implementation of subsequent regulation means that the CFTC rules must be considered by market participants. The recent bitcoin cases provide a warning to those who do not adequately consider the regulatory waters into which they may be wading. An end-user of swaps should not simply defer to its dealer’s characterization of a transaction, particularly when entering into a highly tailored or complex derivative. Oftentimes the characterization of an instrument as being subject to CFTC jurisdiction (or not) is not intuitively obvious on the face of the transaction. Further, transactions conducted outside of the United States often raise unique issues that may not be specifically addressed in CFTC’s rules; in those circumstances, the CFTC may view itself as having jurisdiction, and may apply a U.S.-centric view of the way derivative markets are structured and should operate. It is critical to have in place a process for identifying and analyzing new products and new transactions that you might pursue. Care and caution are the watchwords in this new era of expanded regulatory reach.