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In Depth: Regulation And Enforcement Of The Digital Assets Markets, Part Two – Focus On Enforcement – Commodities/Derivatives/Stock Exchanges

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In last week’s Cabinet News and Views, we examined
the U.S. regulators’ approach to the digital asset space, with
a focus on the
assertion of jurisdiction
by the CFTC, the SEC, prudential
regulators, state executive and legislative branches, and
Congressional initiatives. This week, our focus shifts to
enforcement − what actions the various regulators are taking
in the digital asset space and what we can expect to see in the
near future.

CFTC Enforcement Actions

Over the past few years, the CFTC brought a number of
enforcement actions against participants in the digital asset
markets using its regulatory authority over the U.S. commodity
derivatives markets, which included allegations of running an
unregistered swap execution facility (a “SEF”) and/or
designated contract market (a “DCM”) and a derivatives
clearing organization (“DCO”), failure to register with
the CFTC as a futures commission merchant (an “FCM”), a
commodity pool operator (a “CPO”) and/or a commodity
trading advisor (a “CTA”), as well as fraud, market
manipulation and some other charges. Some of those actions are
discussed below. As the CFTC ramped up its enforcement efforts in
this area, the amounts of civil monetary penalties imposed by the
CFTC increased from nominal in early cases to tens and even
hundreds of millions of dollars in more recent cases. Again, as
noted above, CFTC’s enforcement actions relate to cases that
are clear under the existing authorities, while there are a
multitude of instances where it is not clear whether CFTC’s or
SEC’s jurisdiction applies (see, e.g., the Department
of Justice (the “DOJ”) case involving OpenSea discussed
below).

In a number of enforcement actions, among other things, the CFTC
alleged that the defendants operated a SEF or DCM that was not
registered with the CFTC. For example, in 2015, the CFTC issued an
order filing and simultaneously settling
charges against Coinflip, Inc., d/b/a Derivabit
(“Coinflip”) and its founder, chief executive officer,
and controlling person. The CFTC alleged that Coinflip, without
being registered as a SEF or DCM, operated an online facility named
Derivabit that allowed users to trade standardized U.S.
dollar-denominated bitcoin option contracts in violation of
Sections 4c(b) and 5h(a)(l) of the CEA and the CFTC Regulations
32.2 and 37.3(a)(l). Coinflip agreed to settle the charges without
admitting or denying the findings and conclusions of the CFTC and
to cease and desist from future violations of the CEA.

On October 1, 2020, the CFTC filed a complaint against five
entities doing business as “BitMEX,” as well as
BitMEX’s co-founders, seeking injunctive and other equitable
relief, as well as the imposition of civil penalties, for
violations of the CEA and CFTC regulations. On August 10, 2021, the
CFTC announced that the U.S. District Court for the Southern
District of New York entered a consent order against operators of the BitMEX
cryptocurrency derivatives trading platform. The court found that
BitMEX violated the CEA by operating a facility that offered
leveraged trading of cryptocurrency derivatives to, and entering
into such transactions with, retail and institutional customers in
the U.S. and elsewhere without being approved as a DCM or a SEF.
The court also found that BitMEX violated the CEA by accepting
Bitcoin as margin for digital asset derivatives and entering into
retail commodity transactions without registering as an FCM with
the CFTC. In addition, BitMEX failed to implement a customer
information program and know-your-customer procedures, and failed
to implement an adequate anti-money laundering program. BitMEX was
enjoined from future violations of the CEA and ordered to pay
$100,000,000 of civil monetary penalties. On May 5, 2022, the court
entered consent orders against the three co-founders
of BitMEX stemming from the same CFTC complaint. The order required
each of the founders to pay a $10 million civil monetary penalty
and enjoined them from further violations of the CEA and CFTC
regulations. In parallel criminal actions, the three co-founders
and one more individual were charged by the U.S. Attorney’s
Office for the Southern District of New York with conspiracy to
cause, and willfully causing, BitMEX to violate the Bank Secrecy
Act in which they pled guilty.

The CFTC also brought a number of enforcement actions alleging
that defendants, among other things, illegally offered retail
commodity transactions to their customers without being registered
as FCMs. For example, in 2016, the CFTC issued an order filing and simultaneously settling
charges against an entity where the CFTC alleged that such entity
operated an online platform for exchanging and trading
cryptocurrencies that offered and allowed entry into retail
commodity transactions. According to the CFTC, this entity did not
actually deliver cryptocurrencies purchased on a leveraged,
margined, or financed basis to its customers who purchased them.
Instead, it held those cryptocurrencies on deposit in its own
digital wallets (which did not qualify as “actual
delivery”). Therefore, the statutory exception under Section
2(c)(2)(D) of the CEA was not available, the retail commodity
transactions offered and entered into by this entity were illegal,
and off-exchange commodity transactions and this entity failed to
register as an FCM in violation of Sections 4(a) and 4(d) of the
CEA. The CFTC order required this entity to pay a significant civil
monetary penalty and to cease and desist from future violations of
the CEA.

On September 29, 2021, the CFTC filed charges against 14 entities. The complaints
alleged that 12 of the entities offered to the general public
binary options based off the value of commodities, including
cryptocurrencies, and encouraged their customers to transfer money
or assets to them, without registering as FCMs. The complaints
alleged that two of the entities falsely claimed that they were
members of the National Futures Association and registered as FCMs
with the CFTC.

In another digital asset-related civil enforcement action alleging a failure to
register as an FCM filed on May 19, 2022 in the U.S. District Court
for the Northern District of Illinois, the CFTC charged Sam Ikkurty
(“Ikkurty”) of Portland, Oregon, Ravishankar Avadhanam of
Aurora, Illinois, and Jafia LLC, a company Ikkurty owns in Florida,
with operating an illegal commodity pool and failing to register as
a CPO. In addition, CFTC alleged that the defendants engaged in
fraudulent solicitation of at least $44 million for participation
interests in certain funds invested in digital assets and other
instruments and misappropriated those funds by, among other things,
distributing them to other participants in a manner of a Ponzi
scheme.

On June 2, 2022, the CFTC filed its first-of-its-kind civil enforcement action against Gemini Trust
Company, LLC (“Gemini”), based in New York, for making
false or misleading statements or omitting to state material facts
to the CFTC in connection with the self-certification of a Bitcoin
futures product with respect to, among other things, facts relevant
to understanding whether the proposed Bitcoin futures contract
would be readily susceptible to manipulation. The proposed Bitcoin
futures product was of particular significance since it was to be
among the first digital asset futures contracts listed on a DCM and
was used by market participants as a pricing source for other
financial products referencing Bitcoin.

In a number of other civil enforcement actions, the CFTC also
alleged fraud and misappropriation of customers’ funds related
to digital assets. For example, in 2019, the CFTC filed a civil enforcement action in the U.S. District
Court for the District of Nevada, charging David Gilbert Saffron of
Las Vegas, Nevada and Circle Society, Corp., a Nevada corporation,
charging the defendants with fraud. The CFTC alleged that the
defendants fraudulently solicited and accepted at least $11 million
worth of Bitcoin and U.S. dollars to trade off-exchange binary
options on foreign currencies and cryptocurrency pairs, among other
things. Instead, the defendants misappropriated the funds and used
them for other purposes, including making payments to other
participants “in the manner of a Ponzi scheme.” On March
29, 2021, the court issued the final order and judgment against the defendants
granting a permanent injunctive relief, restitution of $14,841,280
to defrauded pool participants, disgorgement of $15,815,967, and a
civil monetary penalty of $1,484,128.

On March 29, 2022, the CFTC announced that the U.S. District
Court for the Western District of Texas entered into a consent order in an enforcement action brought
by the CFTC against investment firm Kikit & Mess Investments,
LLC and its owner. The court found that the firm misappropriated
more than $7.2 million from investors who intended to trade forex
or cryptocurrency in managed accounts and ordered the defendants to
pay restitution, disgorgement and civil monetary penalties.

On May 13, 2022, the CFTC announced that it had filed a civil enforcement action in the U.S. District
Court for the Southern District of New York against Eddy Alexandre
of Valley Stream, New York, and his company, EminiFX, Inc. where
the CFTC alleged that the defendants fraudulently solicited clients
to trade cryptocurrencies and other commodities and misappropriated
investors’ funds. The CFTC seeks restitution to defrauded
investors, disgorgement, civil monetary penalties, permanent
trading and registration bans, and a permanent injunction against
further violations of the CEA.

On June 30, 2022, the CFTC announced that it has filed a civil enforcement action in the U.S. District
Court for the Western District of Texas charging Cornelius Johannes
Steynberg and Mirror Trading International Proprietary Limited
(“MTI”), a company organized and operated under the laws
of the Republic of South Africa, with fraud and registration
violations in the largest fraudulent scheme involving Bitcoin ever
charged by the CFTC. According to the CFTC, Steynberg created and
operated, through MTI, a global foreign currency commodity pool
with a value of over $1,733,838,372 that only accepted Bitcoin to
purchase a participation in the pool. Steynberg, individually and
as the controlling person of MTI, engaged in an international
fraudulent multilevel marketing scheme, using the websites and
social media, to solicit Bitcoin from members of the public for
participation in a commodity pool operated by MTI in the manner of
a Ponzi scheme.

SEC Enforcement Actions

Using its exclusive jurisdiction over U.S. public securities
markets and financial reporting of public companies, in the recent
years, the SEC brought an increasing number of enforcement actions
against participants in the digital asset market where the digital
assets involved were found by the SEC to be securities or the
market participant did not provide an adequate disclosure. The most
common alleged violations were unregistered offerings and sales of
securities and fraud. Some enforcement actions involved alleged
failures to register as an investment company, failures to register
as a trading facility, as well as market manipulation. However, the
SEC intends to broaden its reach. For example, according to recent
reports, the SEC is scrutinizing non-fungible
tokens and their trading venues to determine whether any of them
are used to raise capital the way traditional securities are
used.

Unregistered sale of securities and fraud were perhaps one of
the most common grounds for SEC’s enforcement actions relating
to digital assets. The SEC brought a number of enforcement actions
alleging unregistered sales of digital assets that it considered to
be securities. For example, on August 6, 2021, the SEC issued its
first order involving securities using the so-called
“decentralized finance” (“DeFi”) technology
where it charged two Florida men and their Cayman Islands company
for unregistered sales of more than $30 million of securities using
smart contracts. According to the SEC, the respondents offered and
sold digital tokens stating that the tokens would pay interest and
profits because investors’ assets would be used to buy
income-generating assets. Based on the Howey test, the SEC found
that the digital tokens sold by the respondents were investment
contracts offered and sold without registration in violation of
Sections 5(a) and 5(c) of the Securities Act of 1933. In addition,
according to the SEC, the respondents did not buy any
income-generating assets with investors’ funds and failed to
disclose that to the investors in violation of Section 17(a) of the
Securities Act and Section 10(b) of the Securities Exchange Act.
The order required the respondents to pay $12,849,354, together
with pre-judgment interest, in disgorgement and each of them to pay
a $125,000 civil monetary penalty.

In a complaint filed by the SEC on April 28, 2022 in
the U.S. District Court for the Southern District of California,
the SEC charged three defendants alleging that the defendants
offered and sold NSG digital tokens that were securities to the
public in an unregistered offering. In addition, the defendants
allegedly created an unregistered trading platform for trading NSG
digital tokens and engaged in market manipulation schemes by
fraudulently creating appearance of trading activity in NSG tokens,
making false and misleading claims to investors and
misappropriating investors’ funds. The SEC seeks permanent
injunctions, disgorgement, with prejudgment interest, and civil
penalties against each defendant.

On February 14, 2022, the SEC filed its first-of-its-kind order charging BlockFi Lending LLC
(“BlockFi”) with violating the registration provisions of
the Investment Company Act of 1940. According to the SEC, BlockFi
offered interest-bearing cryptocurrency accounts to retail
investors, which SEC found to be securities, without registration
and operated as an unregistered investment company because it
issued securities and held more than 40% of its total assets
(excluding cash), in investment securities, including loans of
digital assets to institutional borrowers. In addition, the SEC
alleged that BlockFi made false and misleading statements
concerning the risk level of its investment product. BlockFi agreed
to pay $50 million to the SEC to settle the charges. In addition,
it agreed to pay the same amount to 32 states to settle charges of
state securities laws violations.

Violations of the anti-touting provisions of the federal
securities laws were the focus of the SEC order filed on July 14, 2021. In that order,
the SEC alleged that United Kingdom-based Blotics Ltd, the operator
of Coinschedule.com, a website that profiled offerings of digital
asset securities, violated federal securities laws by failing to
disclose the compensation it received from issuers of the digital
asset securities it profiled. Blotics has agreed to cease and
desist from committing any future violations of the federal
securities laws, and to pay $43,000 in disgorgement, plus interest,
and a civil penalty of $154,434.

Failure to register as a broker-dealer was charged in a complaint filed by the SEC in the U.S. District
Court for the Southern District of New York on August 18, 2020.
According to the SEC, two defendants, for a substantial
compensation, acted as unregistered brokers in violation of Section
15(a) of the Securities Exchange Act and used social media to
promote securities of AirBit Club, an investment scheme that
promised high returns through a purported digital asset trading
program and from the recruitment of others. Failure to register as
a broker-dealer was one of the charges in another complaint filed by the SEC on September 18,
2019, where SEC alleged that ICOBox and its founder Nikolay
Evdokimov raised $14 million by conducting an unregistered offering
of digital asset securities and acted as unregistered brokers by
promoting, offering and selling other digital asset securities for
a fee.

A ramp-up of SEC digital asset-related enforcement actions
sometimes reaches companies whose core business is not related to
digital assets. For example, in an order filed on May 6, 2022 against NVIDIA
Corporation (“NVIDIA”), a designer and manufacturer of
computer graphics processors, chipsets, and related multimedia
software, the SEC alleged that NVIDIA failed to disclose that the
use of its gaming processors in cryptomining was a significant
factor in the company’s year-over-year revenue growth in
violation of Section 13(a) of the Exchange Act and Rule 13a-13
thereunder. NVIDIA agreed to pay $5,500,000 in civil penalties to
settle the charges.

Some SEC enforcement actions dealt with an outright fraud
committed by the defendants and resulted in parallel criminal
charges. For example, in complaints filed by the SEC on April 27,
2022 in the U.S. District Court for the Northern District of
California against Bits Capital and David B. Mata, the SEC alleged that the
defendants raised almost $1 million from investors based on
misrepresentations about an automated digital asset trading bot
that was never functional and misappropriated investor’s funds.
The SEC seeks an injunction, disgorgement, with prejudgment
interest, and a civil monetary penalty. The U.S. Attorney’s
Office for the Northern District of California announced parallel
criminal charges of wire fraud against the defendants.

On April 21, 2022, the SEC filed a complaint in the U.S. District Court for the
Southern District of Florida against MCC International Corp.
(“MCC”), its founders and two other entities controlled
by them, alleging that the defendants engaged in an unregistered
and fraudulent offering of thousands of investment plans called
mining packages where the investors were promised to profit from
MCC’s operations involving cryptocurrency mining, trading and
other activities. The profits were paid to the investors in
MCC’s own digital tokens that were to be redeemed on Bitchain,
a fake unregistered digital asset trading platform created and
managed by the defendants, which in fact prevented investors from
redeeming their digital tokens for cash and required them to buy
additional mining packages or forfeit their investments. Meanwhile,
the defendants misappropriated investors’ funds and used them
to fund their lavish lifestyles. On May 6, 2022, the Department of
Justice unsealed an indictment charging the CEO of MCC in a $62
million investment fraud scheme.

Another recent complaint alleging unregistered sales of
securities in a form of digital assets and fraud was brought by the
SEC on March 8, 2022 in the U.S. District Court for the Southern
District of New York. According to the SEC, the defendants, John
and JonAtina Barksdale engaged in unregistered sales of securities
that involved the Ormeus Coin digital token and defrauded thousands
of retail investors out of more than $124 million. The defendants
used a multi-level marketing campaign, using social media and road
shows, making false and misleading statements to promote the
offering of Ormeus Coin to investors and sold packages that
included Ormeus Coin and an investment into a digital asset trading
program. The SEC seeks injunctive relief, disgorgement plus
interest, and civil penalties. In parallel, the U.S. Attorney’s
Office for the Southern District of New York filed criminal charges
against John Barksdale.

Enforcement by the Department of Justice

In the earlier digital asset-related enforcement actions, the
DOJ filed parallel complaints when CFTC or SEC investigation
uncovered fraudulent activity that warranted criminal charges. On
June 1, 2022, however, the United States Attorney for the Southern
District of New York and the New York Field Office of the Federal
Bureau of Investigation announced an indictment charging Nathaniel Chastain, a
former product manager at Ozone Networks, Inc. d/b/a OpenSea
(“OpenSea”), with one count of wire fraud and one count
of money laundering for using confidential information about NFTs
gained from his position at OpenSea to profit from insider trading.
To conceal his fraudulent activities, Chastain made his purchases
and sales of NFTs through anonymous digital valets and accounts on
the OpenSea platform. The charges that Chastain faces carry a
maximum sentence of 20 years in prison each. Interestingly, the DOJ
did not refer to either the SEC’s or CFTC’s authorities and
did not discuss whether a subject matter related to commodities or
securities and instead focused on conduct under the federal wire
fraud provisions.

State Enforcement Actions

State security regulators also engaged in enforcement actions
relating to digital assets. On April 13, 2022, Texas State
Securities Board issued an emergency cease and desist order to Sand Vegas
Casino Club alleging that Sand Vegas Casino Club and other entities
and individuals who were involved in the issuance and sale of more
than 12,000 “Gambler” and “Golden Gambler” NFTs
to fund a virtual casino business. Purchasers of the NFTs, in
addition to various other benefits, were entitled to pro
rata
shares in profits of the online casinos. According to the
order, NFTs were issued and sold without registration of their sale
in violation of state securities laws, the issuer failed to
disclose material information relating to the NFTs, made misleading
statements about profitability of the investment in the NFTs,
claimed that the NFTs were not subject to regulation under
securities laws and, to confuse investors, used a name and a logo
similar to those of Las Vegas Sands Corporation with which it had
no association. On the same day, Alabama Securities Commission
issued a parallel cease and desist order that contained similar
allegations. Both orders alleged that defendants’ acts would
cause immediate and irreparable harm to the public. Following the
orders, OpenSea, a decentralized NFT trading platform, suspended
the sale of Sands Vegas Casino Club’s NFTs.

Over the last year, a number of the securities regulators have
issued orders concerning the BlockFi companies’
interest-bearing cryptocurrency accounts. On February 14, 2022, the
North American Securities Administrators Association and the SEC
jointly announced a settlement with BlockFi Lending, LLC. As
alleged by the states, BlockFi promoted to retail investors its
interest-bearing accounts for digital assets promising
high-interest returns in violation of state registration
requirements, which resulted in unregistered sale of securities to
the investors without necessary disclosure in violation of state
securities laws. BlockFi agreed to pay $100 million to settle the
charges and stop offering its cryptocurrency accounts to new
investors until its investment product is properly registered. At
the same time, BlockFi was allowed to continue to deploy digital
assets for its existing investors and pay interest to them.
Thirty-two state securities regulators agreed to the terms of the
settlement and more jurisdictions were expected to follow.

Conclusion

As many government agencies are ramping up their enforcement
activity in the digital asset space, it is difficult to predict the
main thrust of the future enforcement actions. However, the recent
trend reveals increased attention to stablecoins (especially after
the recent demise of the Luna and Terra stablecoins) and NFTs, in
addition to the never-ending line of fraud cases. In the absence of
a comprehensive regulatory framework for digital assets, in
addition to traditional enforcement by the CFTC and the SEC, other
federal and state agencies become involved in regulation and
enforcement activity with regard to digital assets. The recently
proposed industry-friendly “Responsible Financial Innovation Act,” if
enacted, may bring more certainty and clarity for the regulators of
the digital asset markets and market participants and replace the
current regulation by enforcement regime maintained by various
government agencies with overlapping jurisdictions.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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