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Bridging the Week: January 16 to 19 and 22, 2018 (Not Feeling Groovy; Registered Investment Funds and Cryptocurrencies; Bitcoin Investment Schemes; Reg SHO) [VIDEO]

The Securities and Exchange Commission’s Division of Investment Management warned sponsors of registered investment funds not to seek approval to trade cryptocurrencies because of many concerns regarding the asset class. Separately, the Commodity Futures Trading Commission publicized two enforcement actions involving alleged fraud in connection with cryptocurrency investment schemes. Various media outlets report that a third action has been filed too, but it has not yet been publicized by the Commission. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • SEC Not Feeling Groovy About Cryptocurrencies – Tells Registered Investment Funds: Slow Down, You Move Too Fast (includes My View);

  • CFTC Files Two Enforcement Actions Charging Fraud in Connection with Cryptocurrencies Sale Schemes (includes Legal Weeds);

  • Broker-Dealer Agrees to Pay US $1.25 Million to SEC to Resolve Alleged Reg SHO Violations (includes Compliance Weeds); and more.

Briefly:

  • SEC Not Feeling Groovy About Cryptocurrencies – Tells Registered Investment Funds: Slow Down, You Move Too Fast: The Securities and Exchange Commission’s Division of Investment Management issued a letter to two industry organizations stating its belief that, as of now, it was not appropriate for investment fund sponsors to seek registration of SEC-regulated funds—such as mutual funds or exchange traded funds—to “invest substantially in cryptocurrency and related products.” This is because “there are a number of significant protection issues that need to be examined before sponsors begin offering these funds to retail investors,” said the SEC.

Moreover, the Division said that if an existing fund able to use a post-effective amendment to substantially invest in cryptocurrencies did so, it would view such act “unfavorably” and might recommend a stop order to the Commission.

The two industry organizations receiving the Division’s letter are the Investment Company Institute and the Securities Industry and Financial Markets Association’s Asset Management Group.

Although the Division noted that “[f]lexibility to innovate” is an important feature of the law governing investment funds and that advocates of cryptocurrencies have suggested numerous potential benefits associated with the product, critics “have raised various concerns regarding transparency of information, trading, valuation and other matters…”

As a result, the Division sought input regarding a number of relevant matters. These include how funds would value cryptocurrencies; choose newly created cryptocurrencies to invest and deal with forks of existing digital products; take steps to assure that they had adequate liquidity to meet redemptions; and comply with custody requirements. The Division also inquired how concerns expressed by some, including SEC Chairman Jay Clayton, regarding the potential for manipulation and other risks associated with cryptocurrencies impacted fund sponsors’ views regarding valuation and liquidity.

The Division implied that, until its questions were answered “satisfactorily,” it was not likely to consider for approval any registered fund to invest in cryptocurrencies. The Division provided no deadline for the two industry groups or others to respond to its questions.

Separately, in unrelated developments regarding cryptocurrencies:

  • TAC Postponed: The inaugural 2018 meeting of the Commodity Futures Trading Commission's Technology Advisory Committee scheduled for January 23, was postponed because of the US government shutdown. Among other topics, the TAC, under the sponsorship of Commissioner Brian Quintenz, planned to discuss topics related to the blockchain and distributed ledger technology, as well as market and regulatory developments related to virtual currencies, at the meeting. No rescheduled date was announced.

  • ICE Backs Cryptocurrency Data Fee: The Intercontinental Exchange, Inc. and Blockstream announced the launch last week of the Cryptocurrency Data Feed. The companies said this feed will include real-time cryptocurrency data from more than 15 global cryptocurrency exchanges (click here for the relevant press release).

  • IOSCO Provides ICO Guidance: The International Organization of Securities Commissions issued an advisory regarding its concerns about initial coin offerings of digital tokens. In many cases, said the IOSCO, there have been instances of fraud in connection with such offerings, and some offerings have been accomplished in violation of law. As part of its advisory, IOSCO affixed an appendix containing hotlinks to commentary by different worldwide regulators regarding ICOs and related matters (click here to access the IOSCO advisory and appendix).

  • Quebec AMF Reiterates Prior ICO Guidance: Quebec separately issued an advisory regarding ICOs that included prior advice describing when digital tokens issued as part of ICOs might be securities (click here to access Quebec’s advisory).

  • Massachusetts Sues ICO Promoters: The Securities Division of the Office of the Secretary of the Commonwealth of Massachusetts filed an administrative complaint against Caviar— a Cayman Islands exempted company— and Kirill Bensonoff, the majority owner of the firm, for engaging in an ICO from Massachusetts in violation of applicable securities laws requirements. Among other things, the defendants were charged with acting as a broker‑dealer without being registered, and offering and selling a security that was not registered or subject to a valid exemption from registration (click here to access the relevant complaint).

My View: Although the process by which the SEC is seeking industry comment on an important topic appears a bit unusual, and at least some  fund sponsors are likely very disappointed by staff’s delay in approving and even threatening to disapprove registered funds to trade cryptocurrencies until further notice, it is at least a positive development that staff has articulated its specific concerns and is soliciting dialogue.

Previously, in its denial of a proposed BZX rule change to accommodate trading of shares in the Winklevoss Bitcoin Trust, the SEC indicated that its principal concern was the lack of a federally regulated market that traded Bitcoin or Bitcoin futures (click here to access the relevant SEC Order). Since that time, trading in cash-settled Bitcoin futures overseen by the CFTC has commenced on the Chicago Mercantile Exchange and the CBOE Futures Exchange, and trading in swap contracts potentially settling in Bitcoin was approved by the CFTC for LedgerX and has been underway for a few months. Clearly, based on the plain language of the prior SEC Order, this should have been enough to give comfort to the SEC to approve investment funds to trade derivatives on CFTC-overseen cryptocurrency markets.

But apparently, this has not been the case as other concerns remain.

Hopefully, responses received by the Division to its solicitation for comment will empower the SEC to promptly authorize investment funds to trade at least some types of cryptocurrencies subject to disclosures and other reasonable and appropriate conditions it may determine, even if the Commission generally remains uncomfortable with the asset class. As CFTC Chairman J. Christopher Giancarlo said last week before lawyers at the ABA Derivatives and Futures Section conference, “I am disinclined to set regulatory policy from personal value judgments as to the social utility of a lawful, emerging technology, however considerable the inherent risks.” (Click here to access Mr. Giancarlo’s full comments regarding the federal oversight of cryptocurrencies.)

  • CFTC Files Two Enforcement Actions Charging Fraud in Connection with Cryptocurrencies Sale Schemes: The Commodity Futures Trading Commission filed two enforcement actions in a federal court in Brooklyn, New York, alleging fraud and other law violations in connection with cryptocurrency investment schemes.

In one action that named CabbageTech, Corp., a NY corporation, and Patrick McDonnell, its owner and controller, the CFTC charged the defendants with unlawfully soliciting customers to send money and virtual currencies for virtual currency trading advice and for the discretionary trading of virtual currencies by Mr. McDonnell. However, alleged the CFTC, the defendants did not provide the promised services and misappropriated their customers’ funds.

The CFTC charged CabbageTech—which conducted business as Coin Drop Markets—and Mr. McDonnell with fraud.

In the other action, the CFTC named as defendants The Entrepreneurs Headquarters Limited (EHL)—a company incorporated in England and Wales—and Dillon Dean, its sole founder, principal, director and officer. The CFTC charged that the defendants solicited Bitcoin from customers in order to pool their funds and invest in financial products, including binary options traded on the Nadex, a CFTC-registered binary options exchange. In reality, claimed the CFTC, the defendants misappropriated customers’ funds, including using assets from some customers to pay other customers in a Ponzi scheme.

The CFTC alleged that EHL and Mr. Dillon also engaged in fraud, and acted in capacities requiring registration under law (i.e., as a commodity pool operator and an associated person, respectively) without being registered.

The CFTC seeks a permanent injunction against all the defendants in both actions, disgorgement and fines, among other penalties.

The media reported that the CFTC also filed a third enforcement action last week in connection with an alleged cryptocurrency investment scheme (click here for a sample article). However, no details were available as of January 12, 2018.

Following publication of the two CFTC enforcement actions, the heads of enforcement of both the SEC (Stephanie Avakian and Steven Peikin) and CFTC (James McDonald) issued a joint statement noting that their agencies would continue to address violations of law and stop fraud in connection with the offer and sale of digital instruments (click here to read the joint statement).

Legal Weeds: The CFTC’s enforcement action against CabbageTech and Mr. McDonnell marked the second time the Commission has brought an enforcement action against defendants that charged fraud in connection with purported offers or sales of spot cryptocurrencies and not futures or swaps based on cryptocurrencies. Last September, the CFTC sued Gelfman Blueprint, Inc. and Nicholas Gelfman, its chief executive officer and head trader, with running a Ponzi scheme related to Bitcoin. The CFTC brought both its most recent and other enforcement action under a relatively new provision of law (enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act) and Commission regulation that prohibits any person from using a manipulative or deceptive device or contrivance in connection with any “contract for sale of any commodity in interstate commerce”—not solely in connection with swaps or a commodity for future delivery on or subject to the rules of any registered entity. (Click here to access CEA Section 6(c)(1), 7 U.S.C. §9(1) and here for CFTC Rule 180.1(a).)

As I wrote at the time the Gelfman Blueprint case was announced, “[t]he CFTC's willingness to use these provisions in response to a fact pattern related to a commodity only – Bitcoin –, and not to futures or swaps based on Bitcoin, is a powerful statement about its view of its own role in the cryptocurrency arena going forward.” (Click here for further details regarding the Gelfman Blueprint enforcement action in the article, “CFTC Files Charges Alleging Bitcoin Ponzi Scheme Not Involving Derivatives.”)

  • Broker-Dealer Agrees to Pay US $1.25 Million to SEC to Resolve Alleged Reg SHO Violations: The Industrial and Commercial Bank of China Financial Services LLC agreed to settle allegations by the Securities and Exchange Commission that it violated Regulation SHO because it failed to close out on a timely basis short equity sales positions of correspondent brokers when the brokers failed to deliver the requisite securities. ICBC agreed to pay a fine of US $1.25 million resolve this matter. According to the SEC, from April 2013 through August 2016, ICBC claimed lawfully available credits against its close out obligations when it did not fully comply with technical obligations to claim such credits. Moreover, alleged the SEC, during the relevant time, ICBC had “institutional knowledge” of its ongoing failure to deliver positions resulting from its impermissible claims of credit through generation of a daily operational report; however, said the SEC, ICBC did not review this report to identify its prolonged failure to deliver positions until January 2015. The SEC noted that it credited ICBC’s remedial acts and cooperation in agreeing to the settlement.

Compliance Weeds: Under Reg SHO (click here to access this regulation at 15 USC § 240.15c3-5), a broker-dealer accepting a short sale of an equity security from a customer (or engaging in a short sale in its own proprietary account) must first borrow the security, enter into a bona fide arrangement to borrow the security, or have reasonable grounds to believe the security can be borrowed before the delivery date. Broker-dealers comply with this so-called “locate requirement” by maintaining so-called “easy to borrow” lists, which set forth equity securities they reasonably believe they can borrow. Absent an authorized basis, brokers that are participants on a registered clearing agency must close out failure to delivery transactions by no later than the beginning of trading on the settlement day following settlement day of the relevant securities (T+4). However, if the participant can demonstrate that a fail occurred from a long sale or is attributable to bona fide market maker activities, it must close out the relevant securities by no later than the beginning of trading on the third consecutive settlement following the settlement date (T+6). Many other very technical requirements may apply. (Click here for background regarding Reg SHO in an SEC publication, Key Points About Regulation SHO.)

More Briefly:

  • FINRA Fines Another Broker-Dealer For Alleged Breakdowns in Custody and Control of Customer Fully‑Paid and Excess Margin Securities: Jefferies LLC agreed to resolve a disciplinary action brought by the Financial Industry Regulatory Authority for violations of requirements to hold customer fully-paid and excess margin securities in good control locations from July 2013 through March 2016. FINRA charged that during this time period, on occasion, Jefferies held certain customer securities in non-US clearance accounts that were subject to liens by the foreign depository; failed to promptly transfer certain shares of a few customers from 14 foreign clearance accounts that were not good control locations to appropriate segregation accounts; and did not have written supervisory procedures reasonably designed to comply with the SEC’s customer protection rule for customer securities held at foreign depositories (click hereto access SEC Rule 15c3-3). Earlier this month, a different broker‑dealer agreed to pay a fine of US $2.8 million to FINRA to also settle charges for not, on occasion, segregating customers’ fully-paid-for foreign and domestic securities in good control locations as required by law. (Click here for background in the article, “FINRA Fines One Broker-Dealer US $2 Million for Flawed Email Review System, and Another Broker-Dealer US $2.8 Million for Inadequate Segregation of Customer Securities” in the Bridging the Week edition of January 7, 2018.)

  • Federal Court Denies a Defendant’s Motion to Disqualify All SEC Trial Counsel in Manipulation Enforcement Action Because of Inadvertent Access to Privileged Communications: Avalon FA, Ltd, one of the defendants named in the Securities and Exchange Commission’s enforcement action against Lek Securities Corporation for manipulation and other law violations, failed in its effort to disqualify all SEC trial counsel because they gained access to privileged communications between Avalon and its defense attorneys. According to the US federal judge presiding over the case in New York City—the Hon. Denise Cote—the US Attorneys’ Office in New Jersey inadvertently provided to the SEC documents relevant to the legal action that the SEC believed excluded potentially privileged material because of express precautions it had taken. However, because of errors by the US Attorney’s Office, potentially privileged material was provided to the SEC’s trial counsel. The trial judge ruled that the SEC’s process in handling the US Attorney-provided material evidenced its respect for the attorney-client privilege, and, in any case, Avalon did not identify any “specific way” it might be prejudiced by the SEC’s possession of potentially privileged documents. (Click here for general background regarding the Lek Securities enforcement action in the article, “US Broker-Dealer, Its CEO and a Non-US Client Sued by SEC for Layering and Other Manipulative Schemes” in the Bridging the Week edition of March 12, 2017.)

  • Canadian Self-Regulator Recommends Areas of Attention for Dealer Members: The Investment Industry Regulatory Organization of Canada provided its summary of compliance priorities for 2018. IIROC indicated that dealers’ cybersecurity preparedness and development of a “strong compliance culture” will continue to be priorities this year, among other types. IIROC is the national self-regulatory organization that oversees all investment dealers and trading activity on debt and equity marketplaces in Canada. Two weeks ago, FINRA announced its examination priorities for 2018. (Click here for details in the article, “FINRA Announces 2018 Examination Priorities; Will Review Role of Firms and Salespersons in Facilitating Cryptocurrency Transactions and ICOs” in the Bridging the Week edition of January 15, 2018.)

  • CBOE Futures Exchange Proposes Change to Trading Halt Rule for Bitcoin Futures: CBOE Futures Exchange proposed revised rules governing trading halts in Bitcoin Futures. Among other things, the amended rules create additional trading halt periods after initial halts when there are further 10% upward or downward futures price movements. The new rules will go into effect on February 1, absent objection by the Commodity Futures Trading Commission.

©2018 Katten Muchin Rosenman LLP

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About this Author

Gary DeWaal, Securities Attorney, Katten Law Firm, New York
Special Counsel

Gary DeWaal focuses his practice on financial services regulatory matters. He counsels clients on the application of evolving regulatory requirements to existing businesses and structuring more effective compliance programs.

Previously, Gary was a senior managing director and group general counsel for Newedge, where he oversaw the worldwide Legal, Compliance, Financial Crimes Prevention (including AML) and Regulatory Developments departments. He also worked for the US Commodity Futures Trading Commission's Division of Enforcement in New York. For several years, Gary taught a course...

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