The U.S. District Court in California ruled that Monex Credit Co.’s (Monex) new precious metals business system is beyond the scope of the Commodity Futures Trading Commission’s (CFTC) jurisdiction provided that Monex delivers the metal within 28 days of the transaction, contractually or actually. The Monex system involves (a) accepting money from retail customers, (b) for the purchase of precious metals, (c) wherein the metals are stored in depositories (subject to Monex – depositories contracts), and (d) customers may get physical possession of the metal if they make full payment, request actual delivery of specific physical metals, and have Monex ship the metals to them, a pick-up location, or the customer’s agent. Commodity Futures Trading Commission (CFTC) v. Monex Credit Co., Case No. 17-1868 (USDC, CDCA, May 1, 2018) on appeal to the 9th Circuit Court of Appeals, Case No. 18-55815 (9th Cir.)(pending).
Regulation of cryptocurrency, also called virtual currency (such as BitCoin (BTC) and Ethereum (ETH)), has not been clarified on the federal level and only a handful of states have regulations governing cryptocurrency. Stated otherwise, in many states, anyone can (i) accept fiat money from a customer, (ii) purchase cryptocurrency for that customer, and (iii) sell, transfer or otherwise broker the purchased cryptocurrency into different cryptocurrency, all without government regulation. Although several CFTC enforcement actions and Department of Justice (DOJ) enforcement actions under the Securities Exchange Act of 1933 have closed down cryptocurrency exchanges or brokers, the CFTC v Monex lower court decision may be a defense with respect to honest cryptocurrency exchanges and brokers.
Extending the Monex lower court decision to cryptocurrency exchanges, at least with respect to CFTC enforcement actions, is not difficult as long as the cryptocurrency exchange complies with the CFTC Actual Delivery Exception described in the Monex case discussed below. However, the 9th Circuit Court of Appeals decision could drastically alter this extension of the Monex lower court ruling. Cryptocurrency exchanges should vigilantly monitor the Appeals Court decision.
In the Monex case, the CFTC alleged that Monex has two businesses involving precious metals. One Monex business, not at issue in this case, required retail customers to pay full price for precious metals. The second business, called the Atlas program, involved Monex offering precious metals on a leveraged, margined, or financed basis to retail customers to purchase precious metals by only paying a portion of the purchase price, and the balance of the purchase price was financed. Atlas Customers have trading accounts and may take open positions in precious metals, but the trading does not take place on a regulated exchange or board of trade. Monex acts as the counterparty to every transaction, and sets the price for every trade.
Atlas customers sign an Atlas agreement, which gives control over the metals traded on the Atlas trading platform to Monex. Atlas customers with open trading positions do not take physical delivery of the metals. The metals are stored in depositories, subject to contracts between Monex and the depositories. Atlas customers may only get physical possession of the metal if they make full payment, request actual delivery of specific physical metals, and have Monex ship the metals to them, a pick-up location, or the customer’s agent. When an Atlas customer opens a long position, Monex transfers the customer ownership of all the metals underlying his position.
The CFTC asserts that this “transfer of precious metals” is just a book-entry in Monex’s records because Monex can close out the customer’s position at any time in its sole discretion, at a price of its choosing, and without notice.
When customers open a short position, Monex claims that it loans the customer metals that the customer immediately sells back to Monex.
The CFTC also argues that this purported “precious metal loan” transfer is just a book-entry in Monex’s records.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 742, 124 Stat. 1376 (2010) (“Dodd-Frank”), expanded the enforcement authority of the CFTC in 2010. CFTC v. Hunter Wise Commodities, LLC, 749 F.3d 967, 970 (11th Cir. 2014). Relevant to the CFTC lawsuit against Monex, Dodd-Frank added CEA § 2(c)(2)(D) (the “Retail Commodity Provision”), which extended the scope of CEA §§ 4(a), 4(b), 4b to apply to covered “retail commodity transactions,” as if they were contracts of sale of a commodity for future delivery, unless the transactions resulted in “actual delivery” within 28 days (the “Actual Delivery Exception”). 7 U.S.C. § 2(c)(D); CFTC v. Worth Grp., Inc., No. 13-80796-CIV, 2014 WL 11350233, at *1 (S.D. Fla. Oct. 27, 2014).
Under the Actual Delivery Exception, only retail commodity transactions “entered into, or offered (even if not entered into), on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis” fall within this authority. 7 U.S.C. § 2(c)(2)(D)(i)(II).
The CEA does not otherwise define the term “actual delivery” in the statute. Worth, 2014 WL 11350233, at *1; Hunter Wise, 749 F.3d at 978 (citing 7 U.S.C. § 1(a)).
Monex argued that the CFTC lacks regulatory jurisdiction over this case pursuant to the Actual Delivery Exception.
The Eleventh Circuit Court of Appeals is the only circuit to have analyzed the meaning of “actual delivery” in the context of the Actual Delivery Exception. Applying the “ordinary meaning of the term,” the 11th Circuit defined “delivery” to mean “‘[t]he formal act of transferring something’; it denotes a transfer of possession and control.” Hunter Wise, 749 F.3d at 978 (quoting Black’s Law Dictionary 494 (9th ed. 2009)). Further, the 11th Circuit concluded that “‘[a]ctual delivery’ denotes ‘[t]he act of giving real and immediate possession to the buyer or the buyer’s agent.’ ‘Actual’ is that which ‘exist[s] in fact’ and is ‘real,’ rather than constructive.” Id. at 979 (citations omitted). The court’s holding does not require that a buyer take actual possession and control of the purchased commodities; it requires instead that the possession and control of commodities that exist in fact be transferred from the seller. Id.
The CFTC proposed a regulation for the Actual Delivery Exception, which provided that “[a]ctual delivery will have occurred if, within 28 days, the seller has physically delivered the entire quantity of the commodity purchased by the buyer, including any portion of the purchase made using leverage, margin, or financing, whether in specifically segregated or fungible bulk form, into the possession of a depository other than the seller and its parent company, partners, agents, and other affiliates.” 76 Fed. Reg. 77670, 77672 (Dec. 14, 2011). Though the Eleventh Circuit did not rely on the final interpretation in construing “actual delivery,” it found that the CFTC’s guidance comported with its construction of the term. Hunter Wise, 749 F.3d at 980.
The CFTC also argued that the transfer of title to metals held at a third-party depository does not constitute “actual delivery.” The Ninth Circuit’s decision in CFTC v. Noble Metals Int’l, 67 F.3d 766, 772 (9th Cir. 1995), a pre-Dodd-Frank case, concerned the distinction between a futures contract and a cash forward contract under the CEA. The CEA excluded cash forward contracts from CFTC jurisdiction if both parties to the contract contemplated and intended future delivery of the actual commodity. Id.
The District Court in the Monex case distinguished the Noble Metals decision for two primary reasons. First, and most notably, it predates Dodd-Frank. The Noble Metals court did not construe “actual delivery” within Dodd-Frank’s statutory framework. The District Court also reviewed the legislative history of Dodd-Frank and particularly the Actual Delivery Exception.
The District Court found that, based on the Eleventh Circuit’s construction of “actual delivery” in Hunter Wise, the CFTC’s own final interpretation, and the legislative history of the Dodd-Frank amendments to the CEA, Monex’s practices of delivering precious metals to independent depositories within 28-days of their purchase by retail customers on margin falls within the Actual Delivery Exception to the CFTC’s authority.
The Court also noted that the Actual Delivery Exception does not bar enforcement of CEA § 6(c)(1) against Monex. Moreover, unlike the Actual Delivery Exception in § 4c, CEA § 6(c)(1) does not limit its enforcement to “any transaction involving any commodity regulated under this chapter.” By its plain language, CEA § 6(c)(1) applies broadly “to any swap, or a contract of sale of any commodity in interstate commerce.” 7 U.S.C. § 9(1). “It is well established that ‘when the statute’s language is plain, the sole function of the courts—at least where the disposition required by the text is not absurd—is to enforce it according to its terms.’” Lamie v. U.S. Tr., 540 U.S. 526, 534 (2004) (quoting Hartford Underwriters Ins. Co. v. Union Planters Bank, N. A., 530 U.S. 1, 6 (2000)). Section 6(c)(1) provides that “[i]t 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.” Id. Thus, it is not similarly limited to transactions regulated by the CEA.
In this instance, the only plausible interpretation of the Dodd-Frank amendments mandate that CEA § 4b alone prohibits fraud and deceptive conduct, CEA §6(c)(1) prohibits fraud-based manipulation, and CEA § 6(c)(3) prohibits market manipulation in the absence of fraud.
As commentary to the above-reported Monex case, this author recognizes that fraud-based actions by the CFTC, the Securities Exchange Commission and the DOJ under the securities law are always risk factors that must be accounted for by cryptocurrency exchangers.