On July 25, 2019, in CFTC v. Monex Credit Company,1 the U.S. Court of Appeals for the Ninth Circuit reversed the district court’s dismissal of the U.S. Commodity Futures Trading Commission’s (CFTC) enforcement action against Monex Credit Company for alleged fraud in precious metals sales. The Monex court addressed two fundamental issues: (1) what constitutes “actual” delivery of a precious metal (that is, a commodity) and (2) whether, for purposes of section 6(c)(1) of the Commodity Exchange Act (CEA),2 the CFTC must allege both fraud and manipulation or whether fraudulently deceptive activity without manipulation of the markets is sufficient. The Monex decision has significant implications not only for metal traders, but also for physical commodity traders as well as those in the cryptocurrency and retail forex markets.3
In summary, the likely broad implications of the Monex decision are:
- Custodians of commodities must take greater care to ensure that “actual delivery” has occurred for purposes of the 28-day exception – a mere book entry is not sufficient;
Owners of commodities must have at least some minimal control over the asset to satisfy “actual delivery”;
- It remains to be seen how the Monex decision will apply to “actual delivery” for crypto-assets, given the CFTC’s prior interpretations;4
- The CFTC will probably follow the Securities and Exchange Commission’s (the SEC) body of law under section 10(b) of the Securities Exchange Act (the Exchange Act),5 and interpret CEA section 6(c)(1) to prohibit manipulative and fraudulent conduct as separate offenses; and
- The CFTC will likely pursue manipulation or fraud claims under CEA section 6(c)(1) not only with respect to derivatives (futures, swaps, and options) but also with respect to commodities.
The facts of the case
Monex Credit Company (Monex) is a California-based trader in precious metals with a long history of litigation with the CFTC. As explained by the Ninth Circuit, under its Atlas program, Monex allowed its retail customers to purchase precious metals, such as gold, silver, platinum, and palladium, on a leveraged or margined basis, where the customer paid only a small portion of the actual cost of a given quantity of the precious metal (for example, 25 percent) and the remainder of the cost (that is, 75 percent) was financed by Monex. Any change in the value of the precious metal was amplified by the margin, and as a result, it was possible that Monex’s customers could owe Monex considerably more than they deposited to open their accounts if the price of the precious metal decreased over the life of the contract (if the customer opened a long position) or if the price of precious metal increased (if the customer opened a short position).
Upon deposit of margin, Monex did not deliver precious metal to its customers; instead, Monex deposited customers’ precious metal in depositories with which it had direct contractual relationships. Monex’s customers would only receive physical precious metal if the customer had paid the full price for their precious metal (that is, if the customer had repaid the full margin in addition to the initial deposit and all applicable fees and service charges which in aggregate will equal to 100 percent or more of the current price of the metal) and arranged for a special delivery of the metal. Furthermore, Monex had absolute control over customers’ accounts and could liquidate a customer’s position at any time, even if the customer’s position was “in the money” (in other words, if the strike price was above the market price of the prevailing market value).
Prompted by a number of CFTC enforcement actions, the Dodd–Frank Act6 amended the CEA by categorizing commodity transactions with non-eligible contract participants7 (that is, retail participants)8 on a leveraged or margined basis as “futures trades.” Traditionally, under the CEA, all futures trades must be carried out on a designated contract market (DCM) (that is., a commodity exchange) and through registered futures commission merchants or brokers (FCMs). Accordingly, unless an exception applies (such as the 28-day exception), it is a violation of the CEA if a retail futures transaction occurs off of a DCM and not through an FCM. In the Monex complaint, the CFTC alleged that Monex was not operating as a registered DCM,9 and that it was not registered as a FCM.10
Notwithstanding the foregoing, the CEA’s DCM and FCM restrictions do not apply to retail leverage commodity transactions where the contract of sale results in “actual delivery” of a commodity within 28 days.11 Therefore, in the Monex case, it was critical for the Ninth Circuit to determine whether the precious metals transactions entered into by Monex’s customers resulted in “actual delivery.”12 The CFTC’s complaint alleged that Monex violated the CEA because it only made “book entry” delivery during the precious metal transactions described above and did not make “actual delivery” of the precious metal to the customer.
According to the Monex court, Monex’s practice did not meet the requirements of the 28-day exception because “the plain language tells us that actual delivery requires at least some meaningful degree of possession or control by the customer.”13 The Monex court clarified that the exception may be satisfied “when the commodity sits in a third-party depository, but not when, as here, metals are in the broker’s chosen depository, never exchange hands, and are subject to the broker’s exclusive control, and customers have no substantial, non-contingent interests.”14
Accordingly, the court in Monex concluded that “actual delivery” had not occurred. The court was not persuaded by the arguments that virtually every transaction involving securitization or a leveraged sale or “even everyday grocery sales” will fail to meet the test of “actual delivery”.15 It appears that the court focused on the level of control over the physical commodity and concluded in the Monex case that the totality of circumstances indicated that Monex had retained full control over a commodity. Arguably, if Monex did not have the exclusive right at any time for no reason at all to liquidate customers’ positions, the court may have been persuaded that there were enough indicia of customers’ control to meet the requirements of “actual delivery.”
A deceptive and manipulative device and the CFTC’s jurisdictional reach
In addition to the violation of section 2(c)(2)(D) of the CEA, the CFTC also alleged a violation of section 6(c)(1) of the CEA and related CFTC regulation section 180.1. Section 6(c)(1) of the CEA mirrors section 10(b) of the Exchange Act and states 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 [CFTC] shall promulgate.”16 CFTC regulation section 180.1 under section 6(c)(1) also prohibits, among other things, employment of manipulative and deceptive devices.17
In the Monex decision, since there was no allegation that Monex manipulated the market, the Ninth Circuit had to decide whether section 6(c)(1) of the CEA covers fraud claims in the absence of manipulation. The court concluded that section 6(c)(1)’s language is unambiguous – “[a]uthorizing claims against manipulative or deceptive conduct means what it says: the CFTC may sue for fraudulently deceptive activity, regardless of whether it was also manipulative.”18
The Monex decision has raised questions about whether the CFTC’s jurisdiction has been dramatically expanded and if any securitization transaction will be subject to the CFTC’s jurisdiction as a leveraged commodity trade (assuming that the counterparty is a retail participant). The CFTC will likely have to clarify the impact of the Monex decision, particularly in light of the August 14, 2019, Consent Order that the CFTC entered with two large food and beverage companies (the Companies). The CFTC had previously filed a complaint against the Companies in 2015 alleging, among other things, that the Companies attempted to use a manipulative or deceptive device in connection with wheat futures contracts traded on the Chicago Board of Trade. In reviewing the Companies’ motion to dismiss in that case, the U.S. District Court for the Northern District of Illinois determined that section 6(c)(1) under the CEA and CFTC regulation 180.1 thereunder were intended to reach only fraudulent conduct. Under the Consent Order, the Companies agreed to pay a civil penalty of $16 million and consented to the entry of an injunction prohibiting future violations of the anti-manipulation provisions of the CEA. Importantly, the Companies denied the allegations and the Consent Order did not include any findings of fact or conclusions of law. The parties’ denial of the allegations and the absence of any findings of fact or conclusions of law make it difficult for interested parties to draw any meaningful guidance from the Consent Order.
Implications for the commodities and crypto-asset industry
The Monex court’s decision has far-reaching consequences beyond the scope of precious metals trading by retail participants. The CFTC has proposed several interpretations relating to delivery of crypto-assets19 to address the concerns raised by market participants and as a result of several enforcement actions and litigation involving crypto-assets.20 The Monex decision will add additional color to this guidance.
For example, cryptocurrency wallet providers that perform cryptocurrency trading on a leveraged or margined basis on behalf of retail participants may become subject to the CEA’s requirement that the wallet provider conduct futures trades on a DCM and that it registers as an FCM if carrying out such trades. The cryptocurrency wallet provider business model does not typically include physical delivery of cryptocurrency to wallet owners within 28 days and includes custody of wallet owners’ cryptocurrency at the wallet provider. Therefore, a cryptocurrency wallet provider offering cryptocurrency trades on a leveraged or margined basis to retail clients may have to comply with the foregoing CEA requirements.
Client Alert 2019-214
- CFTC v. Monex Credit Company, 931 F.3d 966 (9th Cir. 2019) (Monex).
- Commodity Exchange Act, as amended, 7 U.S.C. section 1 et seq.
- The Monex decision follows the logic of the CFTC’s 2016 Bitfinex order that also requires “actual delivery.” See In re BFXNA Inc. d/b/a Bitfinex (Jun. 2, 2016) (Bitfinex).
- See infra notes 12 and 19.
- See 15 U.S.C. section 78j(b) (prohibiting the use of manipulative or deceptive device in connection with the purchase or sale of securities).
- Dodd–Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
- The definition of eligible contract participant (ECP), as defined in CEA section 1a(18), includes financial institutions, certain insurance companies, investment companies subject to regulation under the Investment Company Act of 1940, 15 U.S.C. sections 80a-1 et seq., certain commodity pools, and other regulated entities. See 7 U.S.C. section 1a(18).
- Under CEA section 2(c)(2)(D)(iv), an agricultural producer, packer, or handler is considered to be an “eligible commercial entity” for any agreement, contract, or transaction for a commodity in connection with the line of business of the agricultural producer, packer, or handler. See 7 U.S.C. section 2(c)(2)(D)(iv).
- Engaging in off-exchange transactions is prohibited under CEA section 4(a), 7 U.S.C. section 6(a).
- Failing to register is prohibited under CEA section 4d, 7 U.S.C. section 6d(a)(1).
- CEA section 2(c)(2)(D)(ii)(III)(aa), 7 U.S.C. section 2(c)(2)(D)(ii)(III)(aa).
- Prior to the Monex decision, the Eleventh Circuit had held that “actual delivery” for purposes of the 28-day exception means giving “real and immediate possession to the buyer or buyer’s agent.” See CFTC v. Hunter Wise Commodities, LLC, 749 F.3d 967, 979 (11th Cir. 2014) (quoting Black’s Law Dictionary (9th ed. 2009)). The CFTC had interpreted “actual delivery” as the transfer of title and possession of the commodity to the purchaser as opposed to the mere book entry of a transfer. See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52426 (Aug. 23, 2013). The CFTC’s 2013 release states that in determining whether actual delivery occurred, the CFTC would employ a functional approach and examine how the agreement, contract, or transaction is marketed, managed, and performed, instead of relying solely on language used by the parties, considering “[o]wnership, possession, title, and physical location of the commodity purchased or sold, both before and after execution of the agreement, contract, or transaction, including all related documentation; the nature of the relationship between the buyer, seller, and possessor of the commodity purchased or sold; and the manner in which the purchase or sale is recorded and completed.” Id. More recently, the CFTC has stated that “actual delivery” within the context of virtual currency requires (1) a customer to have the ability to take possession and control of the entire quantity of the commodity, whether it was purchased on margin, or using leverage, or any other financing arrangement and use it freely in commerce within 28 days, and (2) the offeror and counterparty seller not retaining any interest in or control over any of the commodity purchased on margin, leverage, or other financing arrangement at the expiration of 28 days. See Retail Commodity Transactions Involving Virtual Currency, 82 Fed. Reg. 60335 (Dec. 20, 2017).
- Monex, 931 F.3d. at 974.
- The court clarified here that the Monex decision and the application of section 6(c)(1) of the CEA does not apply to “retail cash commodity sales,” but applies to “margined commodity sales,” which is different than shopping on a credit card at a grocery store.
- CEA section 9(1), 7 U.S.C. section 9(1) (emphasis added); see also CEA section 13a-1(a), 7 U.S.C. section 13a-1(a).
- 17 C.F.R. section 180.1.
- Monex, 931 F.3d. at 976.
- For example, in the Bitfinex Order, the CFTC ordered Hong Kong-based bitcoin exchange Bitfinex to pay a $75,000 civil monetary penalty for offering illegal off-exchange financed retail commodity transactions in bitcoin and other cryptocurrencies and failing to register as an FCM. The CFTC’s Order explained that Bitfinex operated an online platform for exchanging and trading cryptocurrencies. Bitfinex permitted users to borrow funds from other users on the platform in order to trade bitcoins on a leveraged, margined, or financed basis. Bitfinex held the bitcoins in deposit wallets that it owned and controlled. The CFTC found that the transactions did not result in actual delivery of bitcoins, and thus Bitfinex could not rely on the 28-day exception. Following Bitfinex, in the Retail Commodity Transactions Involving Virtual Currency release, the CFTC set out its view regarding the actual delivery exception as it applies to virtual currency transactions. As discussed in note 12, supra, the Release proposes two primary factors necessary to demonstrate actual delivery of retail commodity transactions in virtual currency: (1) a customer having the ability to (i) take possession and control of the entire quantity of the commodity, whether it was purchased on margin, or using leverage, or any other financing arrangement, and (ii) use it freely in commerce (both within and away from any particular platform) no later than 28 days from the date of the transaction; and (2) the offeror and counterparty seller (including any of their respective affiliates or other persons acting in concert with the offeror or counterparty seller on a similar basis) not retaining any interest in or control over any of the commodity purchased on margin, leverage, or other financing arrangement at the expiration of 28 days from the date of the transaction. See Retail Commodity Transactions Involving Virtual Currency, 82 Fed. Reg. 60335 (Dec. 20, 2017). The CFTC has also released (1) a “Primer on Virtual Currencies” that provides an overview of virtual currencies and outlines the CFTC’s role and oversight of virtual currencies, and (2) an “Advisory with Respect to Virtual Currency Derivative Product Listings” that clarifies the CFTC’s priorities and expectations in its review of new virtual currency derivatives to be listed on a DCM or swap execution facility, or to be cleared by a derivatives clearing organization. See LabCFTC, A CFTC Primer on Virtual Currencies (Oct. 17, 2017); CFTC Staff Advisory No. 18-14 (May 21, 2018).
- See, for example, CFTC v. 1Pool Ltd., 2019 WL 1605201 (D.D.C. Mar. 4, 2019); CFTC v. My Big Coin Pay, Inc. et al., 334 F. Supp.3d 492 (D. Mass. Sept. 26, 2018); CFTC v. Patrick McDonnel and CabbageTech Corp. d/b/a Coin Drop Markets, 2018 WL 5004861 (E.D.N.Y. Aug. 23, 2018); CFTC v. Gelfman Blueprint, Inc. et al., Case No. 17-7181 (S.D.N.Y., Sept. 24, 2017); In re TeraExchange LLC (Sept. 24, 2015); In re Coinflip, Inc. (Sept. 17, 2015).