In the first case of its kind, a New York federal district court has adopted the position of the Commodity Futures Trading Commission (CFTC) that it has jurisdiction to regulate the virtual currency markets. In so doing, the court has likewise preliminarily enjoined two defendants in an alleged fraudulent scheme to defraud customers operating in those markets and broadly rejected important jurisdictional arguments to the contrary.
Who regulates cryptocurrencies? That is the question. Pursuant to the Dodd-Frank Act, the CFTC has broad enforcement authority with respect to commodities, but it is not altogether clear whether “commodities” include virtual currencies, or that the CFTC has any regulatory authority in this regard. If bitcoin and related virtual currencies are covered commodities, then, pursuant to Section 13a-1(a) of the Commodity Exchange Act (CEA), the CFTC may seek injunctive or other relief when it believes that a person or entity is in violation of the CEA. (“[T]he Commission may bring an action in the proper district court of the United States ... to enjoin such act or practice, or to enforce compliance with this chapter, or any rule, regulation or order thereunder, and said courts shall have jurisdiction to entertain such actions.”)
In 2015, and in the context of an enforcement action, the CFTC first asserted that “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities,” citing Section 1a(9) of the CEA (“commodity” defined to include, among other things, “all services, rights and interests in which contracts for future delivery are presently or in the future dealt in.”).
In January 2018, the CFTC filed an unrelated action in the U.S. District Court for the Southern District of New York against an individual and corporate entity alleging that defendants operated a deceptive and fraudulent virtual currency scheme to induce customers to send money and virtual currencies to defendants in exchange for purported virtual currency trading advice concerning the trading of virtual currencies, including bitcoin and Litecoin, and for virtual currency purchases and trading on behalf of customers under the individual defendant’s direction. Alleging that the customers had lost substantial sums and that others were at risk of likewise suffering such losses, the CFTC sought to enjoin such acts and practices, to compel compliance with the CEA, and to recover civil monetary penalties and remedial ancillary relief, including but not limited to trading bans, restitution, disgorgement, rescission, and pre- and post-judgment interest.
The complaint defines “virtual currency” as a digital representation of value that functions as a medium of exchange, a unit of account and/or a store of value, but does not have legal tender status in any jurisdiction. Bitcoin, Litecoin and other virtual currencies are distinct from “real” currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance. The CFTC alleges that defendants solicited and received fees and investments from customers in various states and countries for the purposes of receiving expert trade signals and trading advice for virtual currencies, and for virtual currency purchasing and trading managed by defendants. The CFTC alleges that, contrary to defendants’ representations, after receiving subscription payments from multiple customers, defendants never provided to such customers continuous, real-time trading signals, advice or trading expertise through its social media chatrooms, through online communications such as via Twitter, or through its website. Instead, says the CFTC, they misappropriated the customer funds.
At the time of the filing, James McDonald, the CFTC’s Director of Enforcement, commented, “This action is among the latest examples of the CFTC’s continuing commitment to act aggressively and assertively to root out fraud and bad actors involved in virtual currencies. As alleged, the Defendants here preyed on customers interested in Bitcoin and Litecoin, promising them the opportunity to get the inside scoop on the next new thing and to benefit from the trading acumen of a supposed expert. In reality, as alleged, customers only bought into the Defendants’ fraudulent scheme. We will continue to work hard to identify and remove bad actors from these markets.”
The individual defendant moved, on February 15, to dismiss the charges on largely jurisdictional grounds. In specific terms, defendant argued that (1) the CFTC lacked standing because virtual currency is not a commodity; and (2) Dodd-Frank’s amendments are not sufficient to permit the CFTC to exercise its jurisdiction over fraud that does not directly involve the sale of futures or derivative contracts.
Following a hearing on March 6, 2018, Judge Weinstein rejected both arguments and entered a preliminary injunction order against defendants, finding that the CFTC had shown a reasonable likelihood that defendants will continue to violate the CEA. The court’s order prohibits the Defendants from engaging in fraud in violation of the Act and requires defendants to preserve books and records and to provide expedited discovery. In so doing, the court concludes that the CFTC has concurrent authority, along with other state and federal administrative agencies, and civil and criminal courts, over dealings in virtual currency. That said, the court recognized that Congress has yet to authorize a system to regulate virtual currency. “The CFTC, and other agencies, claim concurrent regulatory power over virtual currency in certain settings, but concede their jurisdiction is incomplete,” the court notes. Recognizing the gap, the court examined the options available to it, including regulation by the CFTC, the Securities and Exchange Commission, the Treasury Department’s Financial Enforcement Network (“FinCEN”), the Internal Revenue Service, private exchanges themselves, states, or by some combination. The court concluded that virtual currencies, including intangible ones like bitcoin, are commodities because virtual currencies are “goods” exchanged in a market for a uniform quality and value. Further, noting that federal agencies may have concurrent or overlapping jurisdiction over a particular issue or area, the court held that virtual currencies constitute such an area until Congress more fully addresses the problem. The court concluded that “[t]he jurisdictional authority of CFTC to regulate virtual currencies as commodities does not preclude other agencies from exercising their regulatory power when virtual currencies function differently than derivative commodities.”
Why it matters
Although not without its flaws, Judge Weinstein’s opinion is extensive and well-researched, and his decision may have broad implications for the virtual currency markets. It is still altogether unclear whether the states, the SEC, the CFTC or others have the requisite authority to regulate these markets, and the court’s decision implicitly recognizes both the ambiguity and the need for legislative reform. Until then, look for continued tension among regulators over this fast-growing but still relatively unregulated set of markets.