The California federal court judge who, at the end of March, tentatively dismissed 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 final order confirming the dismissal on May 1.
In his ruling, the judge – the Hon. James V. Selna – emphasized the two basic tenets of his tentative order, that:
- actual delivery of precious metals in financed transactions to retail persons falls outside the CFTC’s authority when ownership of real metals is legally transferred to such persons within 28 days – the so-called “Actual Delivery Exception” – even if the seller retains control over the commodities because of the financing beyond 28 days; and
- 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.
The CFTC had argued that Monex’s practices did not result in actual delivery and were a “sham.” The CFTC said, “Customer positions can be liquidated at any time and in Monex’s sole discretion, without notice to customers.” Moreover, “the terms [of the relevant] agreements… deprive customers of all control and authority over any metals that underlie their trading positions.”
However, said the judge, “the legislative history of Dodd-Frank supports the Court’s conclusion that Congress did not intend to exclude the sort of conduct that CFTC alleges Monex engaged in from the ambit of the Actual Delivery Exception.” The judge claimed that if he was to follow the CFTC’s position, every financed transaction would violate Dodd-Frank, and the Actual Delivery Exception under law would be nullified.
The CFTC had also argued that it has broad authority to prosecute fraud under its new Dodd-Frank authority – not just fraud-based market manipulation. However, the judge said he did not see this authority in the relevant law or Congressional dialogue leading to the adoption of the relevant statute. Moreover, he claimed that the Commission itself seemed to concede this point in a July 2011 discussion related to the law and Commission Regulation 180.1 which the CFTC issued when finalizing the regulation. (Click here to access this guidance.) According to the Commission (as quoted by the judge),
“although CEA section 6(c)(1) and final Rule 180.1 give the Commission broad enforcement authority to prohibit fraud and manipulation in connection with a contract of sale for any commodity in interstate commerce, the Commission expects to exercise its authority under 6(c)(1) to cover transactions related to the futures or swaps markets, or prices of commodities in interstate commerce, or where the fraud or manipulation has the potential to affect cash commodity, futures, or swaps markets or participants in these markets.” (Emphasis added by the court. Click here to access Commodity Exchange Act § 6(c)(1), 7 U.S.C § 9(1) and here for CFTC Rule 180.1.)
According to the judge, the CFTC has three basic anti-fraud authorities, and each has a distinct purpose and limitations: § 4b, that solely prohibits fraud and deceptive conduct (click here to access 7 U.S.C. § 6b(a)(2)), § 6(c)(1), that prohibits fraud-based manipulation and § 6(c)(3), that prohibits market manipulation when there is no fraud (click here to access 7 U.S.C § 9(3)).
(Click here for background on the CFTC enforcement action and an overview of the tentative order in the article “California Federal Court Potentially Poised to Limit CFTC’s Dodd-Frank Fraud-Based Anti-Manipulation Authority in Monex Enforcement Action” in the April 22, 2018 edition of Bridging the Week.)
My View: The court’s ruling on the Actual Delivery Exception appears to make perfect sense. If actual delivery within 28 days of the sale of a commodity excludes from CFTC oversight any commodity sold to a retail person on a leveraged or financed basis except where the seller/grantor of financing is not willing to release all liens or control on the financed commodity – even if the financing or leverage is not paid off – the Actual Delivery Exception is meaningless. This is because, realistically, no lender will release its lien or control on collateral supporting financing until a debt is repaid. It seems improbable that Congress would have drafted a law to create a carve-out from CFTC jurisdiction that realistically would never occur.
The difficulty of the CFTC’s position is highlighted in its proposed interpretive guidance on retail commodity transactions involving virtual currencies issued in December 2017, which parallels the CFTC’s 2013 guidance regarding actual delivery of tangible commodities. (Click here to access a copy of the CFTC’s 2013 guidance and here for a copy of the CFTC’s proposed 2017 guidance.) Both proposed examples 1 and 2 suggest situations where actual delivery might only be deemed to have occurred in financed transactions involving virtual currency for retail persons where the financed virtual currencies were delivered to a wallet not controlled in whole or in part by the seller. However, not being able to exercise control would leave the seller with no effective security interest over collateral it financed even when it has not been repaid. This would render the theoretical ability to sell virtual currencies to buyers on finance subject to actual delivery within 28 days a meaningless option.
However, while the court’s view that the CFTC’s ability to prosecute fraud under its new Dodd-Frank authority is limited to fraud-based manipulation might be compelling, it is not as clear to me. This outcome requires a reading of the word “or” in the applicable prohibition to mean “and.”
As drafted, the applicable provision of law reads,
“It shall be unlawful for any person, directly or indirectly, to use or employ, or attempt to use or employ, in connection with any swap, or a contract of sale of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity, any manipulative or deceptive device or contrivance, in contravention of such rules and regulations as the Commission shall promulgate…” (Emphasis added.)
If “or” means “or,” the plain reading of the law suggests that either manipulative or deceptive devices are prohibited, not solely deceptive devices that are manipulative.
The judge insisted that, despite this plain language, a holistic view of this statutory provision considering other sections of law, as well as a review of legislative history, leaves no doubt that the use of “or” was likely careless, and the “or” should be read as an “and.” This analysis is well reasoned and sensible, and it is the basis for his view that only fraud-based manipulation may be prosecuted under this provision. Moreover, I believe the CFTC has unfairly used this statutory provision as the wild junkyard dog of its enforcement arsenal without any leash or other restraint. However, I’m intuitively not so sure about the federal judge’s reasoning. Still thinking about this one!