In a 6 March 2018 Memorandum & Order, US District Judge Jack Weinstein of the US District Court for the Eastern District of New York ruled that the CFTC has standing to bring a fraud lawsuit against New York resident Patrick K. McDonnell and his company, CabbageTech, Corp. (doing business as Coin Drop Markets).
He also ruled that "virtual currencies can be regulated by CFTC as a commodity", adding that "virtual currencies are 'goods' exchanged in a market for a uniform quality and value… They fall well within the common definition of 'commodity'."
Gregory Lisa, a partner in Hogan Lovells’ Washington D.C. and New York offices who represents virtual currency companies and other FinTech companies, noted the significance of this development:
“Many actors in this space – companies, advisors, investors, and individuals – have cautiously watched the differing agencies’ position on the scope of their jurisdiction,” he noted.
“For the CFTC, and perhaps soon for other agencies, there is now a recognition by a federal court of this regulatory reach. Just as important is the Court’s suggestion that perhaps Congress should chart out the regulatory roadmap for how these entities, markets, and currencies are governed.”
Two main questions were in front of the court, namely whether the CFTC can regulate cryptocurrency as a commodity and whether it could "exercise its jurisdiction over fraud that does not directly involve the sale of futures or derivative contracts".
Weinstein answered both questions in the affirmative.
Fragmented regulatory landscape
In his opinion, Judge Weinstein surveyed the fragmented regulatory landscape governing virtual currencies in the US, noting that the CFTC as well as other US agencies claimed “concurrent regulatory power over virtual currency in certain settings, but concede their jurisdiction is incomplete,” and that Congress has not yet passed legislation specifically governing the regulation of virtual currency.
Until then, the court noted, there were several possible alternatives:
- no regulation at all;
- partial regulation by state and federal criminal prosecutions of “Ponzi-like schemes” or by private litigation;
- regulation by the CFTC;
- regulation by the Securities and Exchange Commission (SEC) as securities;
- regulation by the Financial Crimes Enforcement Network (FinCEN) of the US Department of the Treasury as money transmission;
- regulation by the Internal Revenue Service IRS as taxable property;
- regulation by private exchanges and operators to police themselves;
- state regulations (such as that proposed by the New York State Department of Financial Services; or
- a combination of these regulatory approaches.
The Court then reviewed the CFTC’s oversight and involvement in this space, including its policy statements, its administrative and civil enforcement actions, and its allowance of certain cryptocurrency trading on certified exchanges.
At the same time, the Court noted, other agencies – the Department of Justice, the SEC, the Treasury Department/FinCEN, the IRS, and state agencies – “without displacing CFTC’s concurrent authority.”
"Until Congress clarifies the matter, the CFTC has concurrent authority, along with other state and federal administrative agencies, and civil and criminal courts, over dealing in virtual currency," Judge Weinstein noted.
In the absence of this legislative clarity, the Court deferred to the CFTC’s interpretation of its organic statute and jurisdiction, ratifying the agency’s view that "A 'commodity' encompasses virtual currency both in economic function and in the language of the [Commodity Exchange Act]".
As such, the judge agreed with the CFTC’s conclusion that it possessed regulatory authority over such cryptocurrencies traded as futures and derivatives, as well as spot markets underlying those derivative markets, including the ability to enforce against fraud and manipulation in such transactions.
The Court noted, however, that the CFTC itself recognised that it “does not have regulatory authority over simple quick cash or spot transactions that do not involve fraud or manipulation.”
Other lawsuits and prelimimary hearing
In one of several lawsuits filed in January, the CFTC sued McDonnell and his company CabbageTech (doing business as Coin Drop Markets) for "fraudulent solicitations to obtain and then simply misappropriate customer funds".
The agency alleged that McDonnell, who was pretending to be an expert, induced customers to send money and virtual currencies to his company, in exchange for virtual currency trading advice and to purchase and trade virtual currencies on their behalf.
However, the CFTC alleged that McDonnell stopped communicating with his customers after receiving their money and misappropriate their funds.
Following a hearing, Judge Weinstein granted a preliminary injunction barring McDonnell and Coin Drop Markets from further engaging in commodity transactions.
As detailed in its order, the Court found that the CFTC had demonstrated a reasonable likelihood that McDonnell and Coin Drop would continue to violate the CEA.
Among other things, the defendants provided fraudulent advice regarding virtual currency trading, misappropriating customers’ funds and shutting down its website, and ceasing communication with customers.
In addition, according to the Court, the defendants made fraudulent representations regarding their management of customer investments in virtual currency, but “instead of achieving enormous gains on behalf of [Coin Drop Markets] customers, once Defendants had solicited and obtained [Coin Drop Markets] Customer funds for trading …, Defendants ceased communicating with customers and misappropriated the customers’ funds”.
The preliminary injunction prohibits the defendants from engaging in fraud, trading on any commodity exchange or engaging in any transaction involving commodity interest, directly or indirectly, and requires them to preserve books and records and to provide expedited discovery.
If successful in its litigation, the CFTC may obtain a permanent injunction against the defendants, restitution to victims of the alleged fraud, disgorgement of profits from the alleged violations, civil monetary penalties and an industry ban.
Both the CFTC and the SEC have issued warning to investors about scams and fraudulent schemes involving virtual currencies.
Just last month, for example, the CFTC cautioned investors about virtual currency pump-and-dump schemes, describing them as "old scams, new technology".
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