Bridging the Week by Gary DeWaal


Bridging the Week by Gary DeWaal: April 2 to 6 and April 9, 2018 (Kospi 200; Irrevocability; Virtual Currencies; CFTC Jurisdiction)

AML and Bribery    Bitcoin Ecosystem    Block Trades and EFRPs    Bridging the Week    Exchanges and Clearing Houses    Initial Coin Offerings    Managed Money    My View    Position Limits    Trade Practices (including Disruptive Trading)    Whistleblowing   
Published Date: April 08, 2018

A United States appeals court said that the Commodity Exchange Act’s prohibition against spoofing and other conduct could potentially apply in connection with a lawsuit against a US-based trading firm brought by five Korean residents related to transactions involving the Kospi 200 futures contract on the Korean Exchange’s night market. The Court held that, because KRX used CME Globex as its nighttime matching engine, Kospi 200 futures trades matched overnight could potentially be considered irrevocable in the United States, thus warranting application of the CEA. The court took this view even though such trades were KRX trades and not finalized until the following day when they were settled through the KRX Clearinghouse. Separately, most of the defendants in an anti-fraud enforcement action related to virtual currencies brought by the Commodity Futures Trading Commission objected to the Commission’s jurisdiction. Within a few days, however, some of the same defendants consented to the agency’s entry of a preliminary injunction without prejudice to their right to assert their jurisdictional claim in later arguments. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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Briefly:

Last year a federal district court in New York dismissed plaintiffs’ action (for a second time), holding that application of the relevant law (the Commodity Exchange Act) would constitute an “impermissible extraterritorial application” and that plaintiffs had no evidence of a direct relationship with defendants necessary to sustain a claim of unjust enrichment. The appellate court reversed this decision. (Click here to access a copy of the district court’s opinion.)

According to plaintiffs – who filed this action as a class action – the defendants engaged in spoofing-type conduct from January 1 through December 31, 2012, to manipulate the price of Kospi 200 futures for defendants’ own benefit to the detriment of plaintiffs. Each of the relevant transactions was executed on the KRX night market when the KRX was closed for business. During this time, KRX members or traders authorized by such members entered orders that were matched with anonymous counterparties through the Chicago Mercantile Exchange’s Globex electronic trading platform. These trades then cleared and settled on the KRX the next morning after the KRX opened. (Click here for details regarding the KRX night market and CME Globex.)

In their complaint, plaintiffs conceded that they could not identify with precision that any of their counterparties was Tower, but alleged there was a greater than 99.99 percent probability that Tower was a direct counterparty at least once. Moreover, even if Tower was not a counterparty, the plaintiffs claimed they traded at artificial prices caused by the defendants’ alleged spoofing activity. Plaintiffs claimed that Tower earned approximately US $14.1 million as a result of its purported illicit conduct. (Click here to access a copy of Plaintiffs' First Amended Complaint.)

Relying on a 2010 Supreme Court decision (Morrison v. National Australia Bank; click here to access) the district court held that, for futures transactions to be subject to the Commodity Exchange Act, parties to such transactions must “incur irrevocable liability” in the United States or on a US exchange. However, the district court ruled that this was not the case for transactions executed during the KRX night market because trades there were only final when they were cleared and settled on KRX the next day (and not at the moment they were matched on CME Globex). Moreover, the district court held that plaintiffs failed to sufficiently allege that CME Globex was a “domestic exchange” as it is not distinctly registered as an exchange with the Commodity Futures Trading Commission, like CME itself.

The appellate court reversed the district court, however, because, in its view, there were “plausible allegations” that parties to KRX night market transactions incurred irrevocable liability in the United States and this was a sufficient basis for plaintiffs to invoke the Commodity Exchange Act and avoid defendants’ motion to dismiss. This was because, said the appellate court, plaintiffs sufficiently argued that KRX night market trades “bind the parties on matching.” The appellate court also held that, even if there was no direct connection between plaintiffs and defendants on any trade, plaintiffs argued they sustained damages because of defendants’ trading which caused them harm and unjustly enriched the defendants.

My View: A futures contract is only irrevocable after it is executed and accepted for clearing. Until both steps occur, and a clearinghouse is substituted as the counterparty to each of the initial parties to a trade, a futures contract is not fully created let alone binding (See, for example, CME Clearing Rule 804; click here to access.) A complete futures contract = execution + clearing; the two components should be inseparable but both are required. 

Plaintiffs’ amended complaint effectively conceded that, in connection with Kospi 200 futures contracts on the KRX night market, no transactions were finalized until after their matching on CME Globex. Until the contracts were settled in Korea the following day, the transactions were, at best, “essentially binding contracts,” acknowledged the plaintiffs (emphasis added; the plaintiffs relied on a CME Group publication – click here to access (Q/A 9)). However, “essentially binding contracts” and irrevocable contracts are two different things.

As plaintiffs pointed out in their complaint, all KRX night transactions had to be placed through the KRX trading system in the first place. Moreover, both the plaintiffs and defendants had to maintain accounts with licensed Korean brokers to gain access to the KRX trading system, and despite the transactions being matched on CME Globex, the trades were KRX transactions subject to KRX's requirements through and through.  Even after the transactions were routed to and matched on CME Globex, the transactions were not completed until the following trading day in Korea when the KRX Clearinghouse substituted itself as the counterparty to each of the initial persons’ trades. As a result, no fully created and binding futures contracts could have been created until such time.

Despite KRX’s use of CME Globex as a platform to match transactions, the nexus of the relevant trades to the United States was remote and the Commodity Exchange Act should not have applied. The district court in this case got it right; the US Court of Appeals got it wrong. 

In January, the CFTC filed an enforcement action against MBCP, Mr. Crater, Mark Gillespie and the six relief defendants for allegedly engaging in a virtual currency scheme that misappropriated approximately US $6 million from 28 or more persons from at least January 2014 through January 2018. (Click here for details on the CFTC’s enforcement action in the article “CFTC Sues Unregistered Company and Promoters of Fake Virtual Coin for Alleged Fraud and Operating Purported Ponzi Scheme” in the January 28, 2018 edition of Bridging the Week.)

The defendants filed a motion to dismiss the CFTC’s complaint claiming that it lacked jurisdiction under applicable law. According to the defendants, the CFTC may only bring an enforcement action alleging fraud in connection with the offer and sale of a commodity transacted in interstate commerce. However, said the defendants, their virtual currency – named “My Big Coin” – was not a commodity as defined under applicable law because it was not one of the specifically enumerated 30 commodities in the CEA’s definition and it was a not a service, right or interest “in which contracts for future delivery are presently or in the future dealt in.” (Click here for the definition of a commodity under the CEA, 7 U.S. Code §1a(9).) According to the defendants, solely Bitcoin qualifies as a commodity as there are currently futures contracts trading based on that virtual currency only.

However, days after filing a memorandum of law in support of their motion, some of the defendants, including Mr, Crater, consented to the imposition of a preliminary injunction and other relief, although they conceded jurisdiction and venue solely “for the limited purposes” of the court order.

Previously, Maksim Zaslavskiy moved to dismiss a criminal complaint that had been filed against him in November 2017, charging that he engaged in illegal unregistered securities offerings and securities fraud in connection with the offering of digital tokens through initial coin offerings organized by two of his companies, REcoin Group Foundation, LLC and DRC World, Inc. Among other things, Mr. Zaslavskiy claimed in his motion that the digital tokens he tried to create were not securities but cryptocurrencies, and that all currencies, fiat and otherwise, are not securities under applicable law. (Click here for background in the article “Federal Court, Treasury and SEC Provide Further Guidance on Cryptocurrencies; Subject of Criminal Complaint for ICO Asks Court to Dismiss Prosecution Claiming Cryptocurrencies Are Not Securities” in the March 11, 2018 edition of Bridging the Week.)

Separately:

My View: Although I have often exaggerated in public speeches for humor that the CEA definition of “commodity” under applicable law is any noun, the breadth of the definition is truly extensive. As most of the defendants in My Big Pay Coin pointed out in a memorandum to the court, the definition includes 30 specifically enumerated commodities and all services, rights and interests in which contracts are presently or in the future dealt in. However, the definition of a commodity also includes “all other goods and articles” except for onions and motion picture box office receipts. This clause stands alone in the CEA definition of commodity and is not modified by the qualification, "...in which contracts for future delivery are presently or in the future dealt in." As a plain review of the placement of commas and the two uses of word "and" make clear in the CEA definition of commodity, only the phrase "...and all services rights and interests" is modified by the phrase "in which contracts for future delivery are presently or in the future dealt in." 

Thus, the definition of commodity is very broad. It includes (1) 30 enumerated commodities plus all (2) other goods and articles, as well as (3) "all services, rights and interests... in which contracts for future delivery are presently, or in the future dealt in."

Relying on the CEA definition of a commodity, a federal court in Brooklyn, New York, recently upheld the CFTC’s authority to exercise its enforcement power over fraud to virtual currencies sold in interstate commerce and granted the CFTC an injunction against Patrick McDonnell and Cabbagetech, Corp. (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.) Although, in so ruling, the court incorrectly tied "goods and services" to the phrase "in which contracts for future delivery are presently or in the future deal in", the court also expressly held that “[v]irtual currencies are ‘goods’ exchanged in a market for a uniform quality and value.”

The fact that the CEA definition of commodity excludes box office receipts “or any index, measure, value, or data related to such receipts” from the reference to “all other goods and articles,” evidences the intent of Congress to view the term “goods and articles” broadly. Indeed, the exclusion of box office receipts specifically suggests that all other types of receipts are included in the definition of a commodity regardless of form. Presumably this would include physical fiat currencies, electronic credits of fiat currency and all other potential types of payments that could be reflected in receipts – e.g., payments by all virtual currencies. 

More Briefly:

For further information:

Defendants in CFTC Crypto Case First Argue Commission Lacks Anti-Fraud Authority Then Some Consent Voluntarily to Jurisdiction:
/ckfinder/userfiles/files/My%20Bigt%20Coin%20Motion%20to%20Dismiss%20-%20Memo.pdf
/ckfinder/userfiles/files/My%20Big%20Coin%20Consent%20Order.pdf

CME Group Exchanges Sanction Traders for Disruptive Trading, Violating Relation Position Requirements for EFRPs, and Position Limits Offenses:

CME Group Expands Acceptable Types of Collateral to Satisfy House Performance Bond Requirements:
http://www.cmegroup.com/notices/clearing/2018/04/Chadv18-086.pdf

Federal Appeals Court Holds Night Futures Trades on Korea Exchange Matched  CME Globex Potentially Subject to Commodity Exchange Act:
http://brokeandbroker.com/PDF/Choi2Cir.pdf

FinCEN Publishes Customer Due Diligence Requirements’ Frequently Asked Questions:
https://www.fincen.gov/sites/default/files/2018-04/FinCEN_Guidance_CDD_FAQ_FINAL_508_2.pdf

NFA Reminds Members of Some Annual and Ongoing Requirements:
https://www.nfa.futures.org/news/newsNotice.asp?ArticleID=5000

SEC Rewards Whistleblower Who First Alerted Another Regulator:
https://www.sec.gov/rules/other/2018/34-82996.pdf

Trader Criminally Charged for Alleged Spoofing Prevails in Effort to Quash Evidence of Front-Running at Trial:
/ckfinder/userfiles/files/Flotron%20Orders%20Re%20Pretrial%20Motions.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of April 7, 2018. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or other employees.


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