On March 26, 2024, the U.S. Commodity Futures Trading Commission
(“CFTC”) filed a complaint (the “Complaint”) in the
U.S. District Court for the Southern District of New York
(“SDNY”) for injunctive and other relief against several
non-U.S. entities (collectively, “KuCoin”). The Complaint
is noteworthy for several reasons: first, the CFTC clarifies which
“digital assets” would qualify as
“commodities”; second, it succinctly summarizes the
CFTC’s jurisdictional reach in the U.S. and overseas; and
third, it provides a comprehensive analysis of KuCoin’s
operations and contracts traded, while noting which activities the
CFTC deems to be instances of specific violations of the Commodity
Exchange Act of 1936 (“CEA”) and the regulations
promulgated by the CFTC thereunder (the “CFTC
Regulations”)—including the failure to have appropriate
customer identification program policies in compliance with
anti-money laundering laws, in violation of the CEA’s provision
that require FCMs to comply with the Bank Secrecy Act
(“BSA”). The CFTC’s requested relief in the case
includes that KuCoin would be permanently banned from conducting
any regulated business in the U.S., and pay restitution to
consumers and investors as well as significant civil monetary
penalties. Notably, on the same date, the Department of Justice (by
way of the District Attorney’s office of the SDNY) brought additional criminal claims against
KuCoin regarding the BSA and for operating as an unlicensed
money transmitter business.
Background:
a. Qualification as a
“Commodity”
The CEA’s definition of “commodity” found in CEA
§ 1a(9) as well as 17 C.F.R. § 1.3 of the CFTC
regulations provides a list of specific assets (e.g.,
wheat, cotton, rice, etc.) as well as a catch-all category
for “all services, rights, and interests . . . in which
contracts for future delivery are presently or in the future dealt
in.” However, neither the CEA nor the CFTC Regulations provide
a workable definition or a process for determining whether
something would qualify as a “commodity” outside of the
delineated list, unless it is assumed that everything is a
commodity with certain exceptions (the delineated exceptions being
onions and motion picture box office receipts). Several courts have attempted to formulate a test analogous to
the “Howey Test” for securities that could be used to
determine whether something is a commodity, but no such test has
gained prevalence to date. Due to the lack of standard protocol,
the CFTC has historically simply made declarations that do not
carry the weight of law (e.g., in a Chairman’s speech or a court filing), putting the market on notice
that it considers a certain asset to be a “commodity.”
This is exactly what the CFTC did in this case, stating in its
Complaint that a “digital asset” is anything that: (i)
can be stored, (ii) can be transmitted electronically, and (iii)
has associated ownership or use rights; and then the CFTC went on
to explain that “virtual currencies” qualify as
“digital assets” because they (a) are digital
representations of value, (b) function as mediums of exchange, (c)
are used as units of account, and (d) are stores of value. Having
found that Bitcoin (“BTC”), Ether (“ETH”), and
Litecoin (“LTC”) and stablecoin projects USD Coin
(“USDC”) and Tether (“USDT”) are “digital
assets” and “virtual currencies,” the CFTC states
that these instruments are “commodities” traded in
interstate commerce and that there are many contracts for future
delivery (i.e., futures contracts) on digital assets
traded on commodity exchanges (i.e., designated contract
markets (“DCMs”)).
Admittedly, when it comes to digital assets and virtual
currencies, the U.S. Securities and Exchange Commission (the
“SEC”) has also been engaged for some time in “regulation by enforcement” and declared
some to be “securities” as defined in U.S.
securities laws. Whereas the SEC has undertaken “Howey
Test” analyses with respect to individual digital assets in
many of its complaints regarding violations of the securities laws,
the CFTC has not generally opined specifically and
comprehensively on which digital assets are commodities outside of
a select few (including BTC, ETH, LTC and USDT), potentially because
some digital assets are in the “grey area” between a
security and a commodity. Rather, the CFTC has previously asserted
that digital assets writ large are commodities, referencing CEA
§ 1a(9) and stating that “commodities, with limited
exceptions, includes all manner of ‘other goods and articles .
. . and all services, rights and interests . . . in which contracts
for future delivery are presently or in the future dealt
in'”, including “non- traditional goods and
services”.
b. The CFTC’s Jurisdictional
Reach
The designation of most digital assets as
“commodities” is very significant because it
provides the CFTC with (1) non-exclusive enforcement jurisdiction
(i.e., authority to prosecute for fraud and manipulation
involving any “commodity” traded in the interstate
commerce under § 6(c)(1) of the CEA and § 180.1(a) of the
CFTC
Regulations), and (2) exclusive regulatory jurisdiction
(i.e., the authority to regulate how, when, where and by
whom any derivative contract on such “commodity” trades
under § 2(a)(1)(A) of the CEA). The latter jurisdiction is
exclusive, meaning that no other federal agency—including the
SEC—can regulate commodity derivatives (such as futures,
options or swaps). The CFTC’s clear assertion of its
jurisdiction over specific “digital assets” is
significant, as it challenges the SEC’s jurisdictional
reach, especially when the SEC has designated most digital assets as
“securities”. In a statement, Commissioner Pham challenged the jurisdiction of the CFTC over
KuCoin’s proprietary leveraged tokens that allow users to mimic
leveraged long positions in a number of virtual currencies, which
she asserted could be distinguished as “an investment in a
fund, which would typically be a security under the jurisdiction of
the SEC.” CFTC Chairman Behnam also urged Congress to act to end the jurisdictional
confusion in his recent testimony before the U.S. House Committee
on Agriculture.
The Complaint:
a. KuCoin’s Specific
Violations
After establishing its jurisdiction over KuCoin in the
Complaint, the CFTC analyzed the types of contracts KuCoin
offered for trading and the manner they were traded in.
The CFTC explained that a “a fungible promise to buy or
sell a particular commodity, like BTC, ETH, or LTC, at a
fixed date in the future” is a commodity futures
contract. All futures must trade on a registered DCM or, if these
futures contracts are offered to a U.S. person electronically
from overseas, a CFTC-registered foreign board of trade
(“FBOT”). Because KuCoin offered trading in futures
contracts to U.S. retail participants, KuCoin should therefore have
been registered as a FBOT.
Next, the Complaint analyzed “perpetuals” on virtual
currencies and concluded that these contracts qualified as
“swaps” as defined under § 1a(47) of the CEA, and if offered
for trading between multiple participants on a centralized
platform, such platform must register as a swap execution facility
(“SEF”) or a DCM and must only offer these swaps to
eligible contract participants (“ECPs”). Additionally,
the CFTC explained that KuCoin’s proprietary leveraged tokens
are “leveraged, margined and financed retail commodity
transactions” which must either be offered only to ECPs or
executed on a regulated exchange pursuant to § 2(c)(2)(D) of
the CEA. KuCoin was not registered in any of these categories.
The CFTC alleged that KuCoin also acted as counterparty to
derivative contracts on these virtual currencies, solicited orders
and accepted customer assets and margins in some transactions.
These activities can only be carried out by registered futures
commission merchants (“FCMs”) that have implemented
certain customer identification procedures (also known as
“know -your -customer” or “KYC” procedures) in
accordance with the BSA. As KuCoin did not effectively
prevent U.S. customers from participating on its platform, was not
registered as an FCM, and did not implement KYC procedures, the
CFTC concluded that KuCoin was flagrantly disregarding
regulatory requirements with respect to U.S. customers.
b. Requested Relief
The Complaint requests permanent injunction of and an effective
ban on KuCoin’s operations in the U.S. as well as a permanent
ban on any future business in commodity transactions and from
registering with the CFTC in any regulated category in the
future.
The need for this level of sanctions to apply is disheartening
because KuCoin could have taken several inexpensive actions to
effectively comply with the CEA. First, there is already plenty of
authority that some (if not all) digital assets and virtual
currencies qualify as “commodities”. Anyone familiar with
the CFTC’s enforcement program should have been able to
immediately identify compliance gaps with the CEA. Second, the law
is clear that FBOTs, SEFs, DCMs, and FCMs must be registered with
the CFTC to offer trading to U.S. customers. The Complaint begs the
question of whether if KuCoin had registered as a FBOT, most, if
not all violations, could have been avoided. Given that
KuCoin’s trading volume was $3.6 trillion and daily trading
volume was $23 billion, the cost of registration as a FBOT would
have been insignificant, especially in light of them now facing a
total trading ban and potentially criminal sanctions. Third, had
KuCoin registered in an appropriate category, it would have been
unnecessary to prevent U.S. participants from trading on an FBOT or
a DCM, or even a SEF, if such participants qualified as ECPs.
KuCoin would still have to implement the KYC program, but any U.S.
participant would have been able to trade, as was also explained in
the CFTC’s complaint against Binance.
Even though application of the CEA and CFTC Regulations to
digital assets is evolving, and the outer reaches of CFTC’s
jurisdiction are still being tested in courts (and sometimes
challenged by the SEC), KuCoin was on notice and this CFTC
Complaint was arguably preventable, and at a comparatively low cost
to KuCoin.
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.
