The CFTC, actual delivery, and fraud: A federal court gives new guidance

Quick Take

  • CFTC sued Monex for $280 million, alleging violation of the Commodities Exchange Act (“CEA”) related to precious metals margin trading
  • Court of Appeals says that there wasn’t actual delivery of the commodity and the CEA applies to fraud claims without any allegation of manipulation
  • Precedent applies to crypto exchanges because bitcoin and other virtual currencies are commodities under the CEA

U.S. Commodity Futures Trading Commission v. Monex Credit Company, et al. (9th Cir., №18–55815, July 25, 2019) [SDP]

Link to opinion:

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While Commodities Caselaw Minute doesn’t have quite the same ring to it as Crypto Caselaw Minute, U.S. laws governing commodities and, in particular, commodities futures trading are actually kinda important to understand from a “how does it all work” standpoint. Why? Well, for one thing, the Commodities Futures Trading Commission (“CFTC”) says that Bitcoin (and potentially other virtual currencies) are commodities under the Commodities Exchange Act (“CEA”).

This particular case addresses the Commodities Futures Trading Commission’s scope of power to regulate and enforce violations of the CEA. While the defendant here deals in precious metals, given the fact that Bitcoin is a commodity, the case squarely applies to the CFTC’s jurisdiction over crypto margin trading made available to U.S. customers. That’s why you’re reading about it here in Crypto Caselaw Minute.

First, some background to the law. The CEA is a Depression Era (1936 to be precise) law which has been amended many times and which governs the CFTC and its enforcement power. The CEA originally applied to commodities futures markets. Commodity has a really broad definition under the statute, and (in addition to Bitcoin) includes things as varied as sorghum, tallow, cows, and has a catch-all for ‘and all services, rights, and interests (except motion picture box office receipts, or any index, measure, value or data related to such receipts) in which contracts for future delivery are presently or in the future dealt in.”

The Court explains that under Dodd-Frank, which passed in 2010 in the wake of the 2008 financial crisis, the CEA was “extended to commodity transactions offered on a leveraged or margined basis as if they were futures trades.” There’s an exception for “leveraged retail commodity sales that result in ‘actual delivery’ within 28 days.” If you have actual delivery in 28 days, the CFTC’s jurisdiction isn’t triggered.

Monex Credit Company (“Monex”) is the defendant in this case. It sold precious metals and allowed investors to purchase commodities on margin through a program called “Atlas,” which allowed investors to pay part of the full price, with the rest financed by Monex. The CFTC said this was “an illegal and unregistered leveraged retail commodity transaction market” and sued Monex for $290 million for fraud in precious metals sales.

Monex argued that the CEA does not apply to retail commodities dealers who “actually deliver” the commodities in twenty-eight days. It also said that the CFTC didn’t authority over fraud claims without allegations of manipulation. 

The trial court agree with both of Monex’ arguments and dismissed the case. The Court of Appeals disagreed with the trial court and reversed.

The Court explained Atlas as follows: “Once a customer opens an account, she may take open positions in precious metals. But the trading occurs ‘off exchange’ — that is, it does not happen on a regulated exchange or board of trade. Instead, Monex controls the platform, acts as the counterparty to every transaction, and sets the price for every trade.”

One of the risks with trading on margin is that if the value of the asset goes below a certain threshold, the account can be liquidated. Per the Court, “[o]ver the last eight years, Monex has made margin calls in more than 3,000 Atlas accounts and has force-liquidated at least 1,850.” At the same time, “Monex also retains sole discretion to liquidate trading positions without notice to the customer if equity drops too low, and it controls the price for every trade.” Also, commissions and fees came directly out of customer accounts (reducing their equity and thereby increasing liquidation risk).

Monex doesn’t actually “hand over any metals” and customers never actual control a commodity. The metals are kept in third party depositories, and the only way customers can get them is if they pay in full and either have the metals shipped to them or pick them up. “According the CFTC, Monex simply makes a ‘book entry’ when customers make trades — nothing more.”

The CFTC alleges the Atlas is designed for customers to lose money, that it isn’t “safe, secure or profitable,” as advertised, and has that Monex has been violated the CEA since 2011. In fact, it alleges, “Atlas is designed so that when customers lose, Monex gains.” Among other things, it pointed out that as the counterparty to every transaction, Monex benefits from “large price spreads at the customers expense.” In addition, it engaged in high pressure sales tactics while systematically understating the risks associated with trading.

The CFTC sued a number of Monex companies and two principals, alleging four separate CEA violations. The District Court said that three counts failed because Monex fell within the actual delivery exception and that the 4th failed because CFTC alleged only fraud, not fraud AND manipulation.

The Court of Appeals first examined the “actual delivery” exception. Monex argued that actual delivery took place when the commodities were delivered to third party depositories for the buyer’s benefit. The Court disagreed: “actual delivery requires some meaningful degree of possession or control by the customer.” While using a third party depository isn’t fatal to this exception, it didn’t work here because the metals were in a depository chosen by the broker, “never change hands, and are subject to the broker’s exclusive control, and customers have no substantial, non-contingent interest.” The fact that the commodity serves as collateral doesn’t change the analysis, according to the Court.

In short, “actual delivery [] unambiguously requires some degree of possession or control.” Transfer of title to the customer and delivery to a third party depository doesn’t satisfy this when it’s “simply a sham.” In this case, the customers had no contractual right to the metal, which was in Monex’s total control and could be liquidated by it at any time.

Monex’s second angle of attacks was that the CFTC only alleged fraud, not fraud and manipulation. The relevant statutory language prohibits the use of “any manipulative or deceptive device.” The trial court said “or” should be read as conjunctive, meaning “and”. The Court of appeals disagreed — “or” means “or”, it reasoned; “[w]hen the word ‘or’ joins two terms, we apply a disjunctive reading.” Furthermore, this particular part of the CEA “is a mirror image of s 10(b) of the Securities Exchange Act which the Supreme Court has interpreted as a ‘catch-all clause.’” Bottom line — this Court says the CFTC doesn’t have to allege market manipulation under the section of the CEA raised here. Fraud is enough.

What does this all mean? Well, we have seen aggressive enforcement action by the CFTC in relation to Bitcoin and other virtual currencies in the past several years. What “actual delivery” means in connection with bitcoin margin trading has vexed others already. For example, the Bitfinex exchange ran afoul of the “actual delivery” requirement back in 2016 and entered in a consent order over a very similar allegation:

Bitfinex’s retail-financed commodity transactions in bitcoin did not result in actual delivery to the Financing Recipients who traded on Bitfinex’s platform. Bitfinex did not transfer possession and control of any bitcoin to the Financing Recipients, unless and until all liens on the bitcoin were satisfied. Prior to satisfaction of the liens, the Financing Recipients’ bitcoins were held in an omnibus settlement wallet owned and controlled by Bitfinex, and to which Bitfinex held the private keys needed to access the wallet. Bitfinex’s accounting for individual customer interests in the bitcoin held in the omnibus settlement wallet in its own database was insufficient to constitute “actual delivery.” See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426, 52,428 (Aug. 23, 2013) (“book entry” purporting to show delivery insufficient). Similarly, when Bitfinex changed its model in August 2015 and January 2016, it retained control over the private keys to those wallets, and the Financing Recipients had no contractual relationship with the third party firm that established the wallets.

The CFTC subsequently issued a proposed interpretation regarding the meaning of actual delivery in connection with retail commodity transactions involving virtual currency, supplementing its 2013 guidance referenced in the quote above. As of today, this guidance has not finalized.  While this area of law is not entirely settled, we now have more authority from a federal court about what “actual delivery means” and the authority is helpful additional precedent.

Enforcement activity involving fraud in connection with margin trading seems likely to be another continued angle of attack, particularly when one considers the description of the allegedly fraudulent activity CFTC alleges and the similarity to behavior by some who serve or have served U.S. customers. Assuming courts in other federal circuits agree that manipulation is not a requirement, this may lower the threshold for the CFTC to take action over crypto exchanges for past and present violations.

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