The California federal court judge hearing the enforcement action by the Commodity Futures Trading Commission against Monex Deposit Company and other defendants for alleged fraud in connection with their financed sale of precious metals to retail persons issued a Tentative Order in late March dismissing the Commission’s complaint.

The court’s preliminary decision – which could ultimately be issued “as is” or modified — said that actual delivery of precious metals in financed transactions to retail persons falls outside the CFTC’s authority when ownership of real metals is transferred to such persons (e.g., through book entry), even if the seller retains control over the commodities because of the financing. Moreover, the court provisionally held that the CFTC could not use the broad anti-fraud and anti‑manipulation authority enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act to prosecute acts of purported fraud except in instances where the alleged fraud affected or potentially affected the market or in cases of fraud‑based manipulation.

Last year, the CFTC sued MDC and two affiliated companies (collectively, “Monex”), along with Louis Cabrini and Michael Cabrini, the firms’ principals, in a federal court in Illinois. The Commission alleged that, in connection with Monex’s precious metals transactions, retail clients purchased and sold precious metals, paid only a portion of the purchase price, and either borrowed the difference (for purchases) or borrowed the metal (for sales). Although Monex delivered customers' precious metals to an independent warehouse and transferred title to the customers, it retained control over the commodities to protect itself in case a customer defaulted on his/her repayment or margin obligations.

The CFTC charged that these leveraged purchases and sales to retail clients constituted prohibited off-exchange futures contracts, and that Monex operated as a futures commission merchant without required registration. In making this claim, the CFTC relied on provisions of law that require all contracts for commodities for future delivery to be executed on or be subject to the rules of a designated contract market and offered and sold through a licensed broker (e.g., a futures commission merchant). (Click here to access 7 U.S.C § 2(c)(2)(D(i)), here to access 7 U.S.C. § 6(a)(1), and here to access 7 U.S.C. § 6d(a)(1).) Although the CFTC conceded these requirements do not apply to outright sales of commodities to retail persons, it said the requirements apply when the sales are financed or on leverage and a firm retains control over its customers' commodities beyond 28 days – even if to protect itself in connection with its financing – because actual delivery has not occurred within 28 days. (Click here to access 7 U.S.C § 2(c)(2)(D)(ii)(III).)

In addition, the CFTC claimed that Monex made material misrepresentations to its customers and that the misstatements constituted fraud. The CFTC based these charges on a provision of law that prohibits fraud in connection with illegal, off-exchange futures transactions (click here to access 7 U.S.C.§ 6b(a)(2)(A)), as well as the authority given to the CFTC under Dodd-Frank that prohibits the use or employment of any manipulative device, scheme or artifice to defraud and a related CFTC rule. (Click here to access 7 U.S.C § 9(1) and here for CFTC Rule 180.1.) The Dodd-Frank provision, argued the CFTC, applies to both fraud in connection with off-exchange futures transactions and to spot market transactions in commodities where there are no derivatives.

In the Tentative Order, the federal court judge rejected the CFTC’s legal foundation for its charges and granted the defendants’ motion to dismiss for two principal reasons.

First, the Court did not accept the Commission’s view that Monex’s leveraged metals transactions were like futures contracts and thus subject to provisions of law that imposed registration requirements on brokers of such contracts. The CFTC had claimed that, although Monex transferred physical metals to independent depositories for the account of the retail clients, its retention of control over the precious metals negated that it made actual delivery of the commodities. However, said the court, if this view was correct, “every financed transaction would violate Dodd-Frank… and the result would be to eliminate the Actual Delivery Exception from the [relevant law].”

The Court then ruled that, since Monex’s transactions were not prohibited off-exchange futures transactions, they were not subject to the CFTC’s traditional anti-fraud prohibition that applies to transactions in futures and not to transactions in commodities.

Second, the Court concluded that enactment of the Dodd-Frank provision, which prohibits the use or employment of any manipulative or deceptive device, was meant solely to assist the CFTC “to protect market participants and promote market integrity.” As a result, the Court declined to find that the law “so dramatically augmented the CFTC’s regulatory authority to cover all fraud in connection with retail commodity transactions...” Accordingly, Monex could not be held liable under the Dodd-Frank provision as pleaded by the CFTC. The CFTC was invited, however, to amend its complaint to plead that Monex's purported fraud was in connection with market manipulation.

The Court’s Tentative Order was subject to oral argument by the parties on March 27. A final decision is pending. (Click here for some background regarding the relevant judge's (The Hon. James Selna) practices regarding tentative orders.)

The CFTC’s action against Monex was transferred to a federal court in California from Illinois in October 2017.

(Click here for additional details on the CFTC enforcement action against Monex in the article “Retail Metals Dealer and Principals Sued by CFTC for Illegal Transactions and Fraud” in the September 10, 2017 edition of Bridging the Week.)

Legal Weeds: If adopted “as is,” the California federal court’s proposed ruling in Monex could have a chilling effect on the CFTC’s enforcement efforts against persons selling virtual currencies who do so on leverage or who engage in alleged fraudulent practices. This is because such a ruling would raise questions regarding the CFTC’s authority to bring such actions in the first place.

In 2016, the CFTC settled an enforcement action against BFXNA Inc. d/b/a Bitfinex, claiming that the firm operated a platform that enabled retail persons to buy and sell virtual cryptocurrencies and to finance their transactions. However, because Bitfinex purportedly retained control over such transactions after the financing – much like the CFTC alleged against Monex –, the CFTC alleged that actual delivery did not occur. As a result, the transactions were akin to futures contracts, and Bitfinex should have been registered as an FCM in order to engage in such activities. (Click here for further details regarding this CFTC action in the article “Bitcoin Exchange Sanctioned by CFTC for Not Being Registered” in the June 5, 2016 edition of Bridging the Week.)

Moreover, more recently, the CFTC proposed guidance that, for sales of virtual currency to retail persons, the Commission would consider “actual delivery” to have occurred solely when the person could take “possession and control” of all purchased cryptocurrency, use it freely no later than 28 days from the date of an initial transaction and do so unencumbered. This would require neither the offeror nor the seller, or any person acting in concert with such persons, retaining any interest or control in the virtual currency after 28 days from the date of the transaction. This would presumably preclude a seller from retaining control over the cryptocurrency by having authority over a wallet containing such commodity even when the seller financed the purchase. (Click here for details regarding this proposal 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.)

If the federal court hearing the CFTC Monex action were to issue its Tentative Order “as is,” the ruling could serve as precedent for persons to challenge the CFTC’s jurisdiction over financed virtual currency transactions (as well as other financed commodity transactions) to retail persons where sellers retain control.

Additionally, the CFTC has liberally applied the Dodd-Frank law that prohibits the use or employment of any manipulative device, scheme or artifice to defraud, as well as the parallel CFTC rule. This is because the CFTC has regarded the provision of law “as a broad, catch-all provision reaching fraud in all its forms – that is, intentional or reckless conduct that deceives or defrauds market participants.”

Relying on the these provisions, the CFTC has brought a wide range of enforcement actions, including the JP Morgan “London Whale” case, and cases based on allegations of illegal off-exchange metals transactions, claims of more traditional manipulation of wheat, allegations of spoofing and claims of insider trading. (Click here for background in the article “CFTC Brings First Insider Trading‑Type Enforcement Action Based on New Anti‑Manipulation Authority” in the December 6, 2015 edition of Bridging the Week.) More recently, in its 2017 enforcement action against Gelfman Blueprint, Inc. and Nicholas Gelfman, its chief executive officer and head trader, the CFTC claimed that the defendants’ purported fraudulent conduct running a Ponzi scheme related to Bitcoin violated these provisions of law.

An adverse ruling as proposed in the Monex enforcement action could force the CFTC to more narrowly focus its enforcement actions under the controversial Dodd-Frank provision, leaving the Commission to bring lawsuits only where it can allege that a purported fraud affected the market or constituted fraud-based market manipulation. More likely, however, the CFTC would continue its enforcement activities “as is” and seek to resolve what would then be a split among courts’ rulings in different regions of the US regarding the scope of the relevant section of Dodd-Frank. Recently, another federal court – one in Brooklyn, New York – upheld the authority of the CFTC to exercise its enforcement authority in connection with alleged fraud in connection with spot trades in virtual currencies where the CFTC relied on the Dodd-Frank law and its own parallel rule. (Click here for details 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.)