Crypto Caselaw Minute #47–8/1/19

This week’s Crypto Caselaw Minute deals with an appeal of a conviction for trying to takeover a federal credit union to hide bitcoin activity, the long running litigation surrounding Mt. Gox, and a case brought by the CFTC against a precious metals trader that is precedent for virtual currency companies. This week’s a long read, so buckle up.

Disclaimer: These summaries are provided for educational purposes only by Nelson Rosario and Stephen Palley. They are not legal advice. These are our opinions only, aren’t authorized by any past, present or future client or employer. Also we might change our minds. We contain multitudes.

(As always, Rosario summaries are “NMR” and Palley summaries are “SDP”. Image credit: https://pixabay.com/photos/euro-dollar-the-european-union-1974712/ (Pixabay license).

United States v. Lebedev et al., 2019 U.S. App. LEXIS 22286(2nd Cir. decided July 26, 2019)[NMR]

• Second Circuit Court of Appeals rejects appeal of defendants that schemed to take over a federal credit union to hide bitcoin transactions
• Yuri Lebedev was in charge of IT at a Florida bitcoin exchange that sought to acquire control over a federal credit union in New Jersey where Trevon Gross was the chairman
• The Court found that the overwhelming evidence at trial was sufficient to convict both of them of multiple counts of fraud, and given Gross’ leadership role his enhanced sentence was warranted

Link to opinion: https://law.justia.com/cases/federal/appellate-courts/ca2/17-3691/17-3691-2019-07-26.html

This is an opinion in a consolidated appeal from two defendants that were convicted of a variety of offenses including operating an illegal bitcoin exchange and conspiring to use a federal credit union for illegal purposes. Both of the appellants, ie the defendants who appealed their convictions, argued that the district court that heard their case made a variety of evidentiary errors, and generally speaking, imporperly handled their case and conviction. The Court disagreed and affirmed the lower court’s decision. This case covers a lot of ground, let’s dig in.

Yuri Lebedev was convicted of wire fraud, bank fraud, conspiracy to commit wire fraud and bank fraud, and making corrupt payments with the intent to influence the officer of a financial institution. That’s bad. The other appelant in this case is Trevon Gross. Gross was originally convicted of receiving corrupt payments as an officer of a financial institution. Oh. As should be readily apparent Lebedev and Gross were in cahoots, accordingly, they were both further convicted of conspiracy in violation of 18 USC 371, also known as conspiracy to defraud the United States. What exactly did they do, and why did they appeal their original convictions?

So, this is a doozy of a tale. Lebedev worked in IT at a bitcoin exchange based in Florida called Coin.mx. The exchange opened bank accounts in the name of the Collectibles Club, “which falsely purported to be a private members’ association dedicated to collecting and exchanging memorabilia.” Not a great idea. In addition, “Coin.mx also processed credit card transactions listing the Collectables Club as the merchant. Neither Coin.mx nor the Collectables Club registered with federal regulators as a money-transmitting entity or obtained state licensure for that purpose.” Definitely a bad idea.

Eventually, the leadership at Coin.mx decided to try and seek control of a credit union. In April 2014, Coin.mx approached Gross who was chairman of a credit union called HOPE FCU in New Jersey about trying to take the credit union over. In a footnote, the Court explains that “[b]y taking control of a credit union, Coin.mx no longer risked being shut down by banks that uncovered the true nature of the Bitcoin transactions. Customers could open accounts at the credit union and use their accounts to buy Bitcoins from
Coin.mx.” It may not seem relevant yet, but Gross was also head pastor at a nearby church in New Jersey.

How does a bitcoin exchange in Florida attempt to take over a credit union in New Jersey? By agreeing to make donations to the church where the chairman of the credit union is also the head pastor, and conspiring to have the chairman get them appointed to the credit union’s board of course. Coin.mx made two $15,000 donations, and then a third donation of $120,000 was made by another company called Kapcharge. Kapcharge was a Canadian payment processor who wanted to process ACH transactions through HOPE FCU. Eventually, as always seems to happen in these situations, there was a falling out between the parties, the regulators got suspicious, and people started getting indicted in 2016. Okay, so what was appealed?

On appeal, Lebedev argued “that there was insufficient evidence that he committed wire fraud because his role in Coin.mx’s scheme — deceiving financial institutions concerning the nature of Coin.mx’s business — did not harm or risk harming those financial institutions.” The Court disagreed explaining that “[t]he evidence at trial demonstrated that Coin.mx was a money service business that was both unlawful and carried a higher risk of fraudulent transactions,” and given that “Lebedev’s role in Coin.mx’s scheme was to disguise Coin.mx’s Bitcoin transactions through front entities such as the Collectables Club” this made it more likely institutions would process these transactions, thereby depriving them of important financial information and exposing them to risk they didn’t know about.

With respect to the bank fraud charge, the Court said “there was sufficient evidence showing that Lebedev caused false information to be sent to financial institutions to disguise the fact that their customers were transacting business with an unregistered Bitcoin exchange.” This was done “with the intent to obtain funds under those institutions’ custody and control…[and]… by approving credit-card transactions, banks advanced Coin.mx their own funds that would later be paid back by customers.” That was enough for a jury to reasonably convict Lebedev.

Gross took a different approach with his appeal and attacked the witnesses and testimony that were brought against him at trial. The first witness was an accountant and litigation consult who testified to the methods used by Gross for the accounts at the credit union. At one point the witness said FIFO (first in first out) for handling funds “made sense.” Gross claimed this amounted to giving an expert opinion, and since the accountant was not brought in as an expert witness the evidence should be thrown out. The Court wasn’t having any of that. The second challenge was against the admissibility of statements made by his co-conspirators, because Gross claimed he withdrew from the conspiracy when the dispute between the parties occurred. The Court explained that he didn’t actually withdraw, because he still maintained a relationship with the payment processor that made the third donation. There was another challenge to a government agent that testified, and Gross challenged his indictment claiming the evidence against him was so far from his charged crimes, and given the story so far you can probably deduce that the Court said no to all these things.

Gross also challenged the sentence he was given, 60 months, and the restitution he was required to pay, $126,771.82. Lebedev was given 16 months, forfeiture, and supervised release. Why did Gross get a more severe sentence? Well, the government applied a leadership enhancement, and a commercial bribes enhancement against him, which on appeal he argued both were improper. The Court didn’t buy it. Remember, Gross was the chairman of the credit union. He was essential to the scheme, and put the institution at risk. As for the restitution, Gross claimed the institution failed after his activity in the conspiracy, and the Court said but for his actions the credit union wouldn’t have been put in a position to fail.

This case doesn’t really offer up any lessons other than if you engage in a conspiracy to defraud the United States and take over a credit union to hide bitcoin transactions, I mean, what do you think is going to happen?

Pearce v. Karpeles, 2019 U.S. Dist. LEXIS 125056 (E.D. Penn. decided July 26, 2019)[NMR]

• Class action lawsuit in Pennsylvania against Mark Karpeles for his involvement in Mt. Gox moves forward
• The Court denied Karpeles motion to dismiss for personal jurisdiction, because Karpeles had thousands of customers in Pennsylvania and he was CEO of Mt. Gox
• Exercising jurisdiction over Karpeles was in line with traditions of fair play and substantial justice, because Pennsylvania has an interest in protecting its citizens and Karpeles availed himself of the benefits of the jurisdiction

This class action lawsuit involves a very well known name in the crypto space, Mark Karpeles, who is the defendant here in a case born out of the great Mt Gox collapse. I feel like the Mt Gox collapse should be referred to in the crypto community as “The Incident,” or “The Day the Coins Fell,” or something similarly grand. If you are not familiar with the “The Day the Coins Fell” you can read an excellent writeup of “The Incident” here. Anyways, in this decision the Court denied Karpeles motion to dismiss for lack of personal jurisdiction. We covered the initial case in CCM #1, which you can find here.

Gregory Pearce is a Pennsylvania resident who created an account on Mt. Gox to trade bitcoin in November 2013. He eventually tried to make a withdrawal at the end of January 2014, right around the time that everyone realized Mt. Gox had a major problem on their hands. Needless to say, the withdrawal never went through.

In the initial filing in January of 2018, Pearce tried to sue Karpeles and Mizuho Bank. Mizuho Bank handled deposits and withdrawals for Gox customers based in the US. Mizuho got themselves dismissed from the lawsuit in March of 2019 due to a lack of personal jurisdiction (they had no contact with Pearce and were merely incidental to the whole thing) leaving Karpeles as the sole defendant. Karpeles then moved to dismiss the case for lack of personal jurisdiction. This opinion denied that motion.

When considering a motion to dismiss the Court “must consider allegations made by plaintiff as true and construe all disputed facts in favor of the plaintiff.” Next, the Court walks through the steps of finding personal jurisdiction over the defendant. Here, the Court had to determine whether they had jurisdiction over Karpeles, and whether the exercise of jurisdiction violates the Due Process Clause of the Constitution.

Right out of the gates the Court stated they had specific personal jurisdiction over Karpeles. Their reasoning? Karpeles had availed himself of the benefits of Pennsylvania by “soliciting business from Pearce and thousands of other Pennsylvania residents through the Mt. Gox website.” Yeah, hard to argue there. Put another way, “[s]ince Mt. Gox actively transacted business over the internet by providing an interactive website that engaged in business with thousands of Pennsylvania residents, this Court’s exercise of personal jurisdiction is proper.” The Court really hammered home this point when it pointed to the complaint and said:

Specifically, we point to Mt. Gox’s website, which allows users to: open and
manage accounts; provide Mt. Gox with their address and personal information; make purchases and trades on the Exchange; transfer or deposit cash directly into their Mt. Gox accounts; make withdrawals from the Exchange; and allow users to purchase a “YubiKey” that would be sent to their address.

The Court also points to two sister cases in federal courts in Illinois and California. We covered the Illinois case in CCM #27, which you find here. As the Court said, their finding of personal jurisdiction here in Pennsylvania is bolstered by the findings of personal jurisdiction over Karpeles in Illinois and California. “The Day the Coins Fell,” has produced a lot of litigation in the US and elsewhere. Karpeles tried to argue that he shouldn’t be personally liable for the acts of his agents, and the things that surrounded the collapse of Mt. Gox, but the Court paid that no mind stating that he was CEO, and it was his ship.

Once the Court found that they had personal jurisdiction over Karpeles they had to answer the question of whether it was fair to exercise that jurisdiction. The Court looked to factors laid out by the Supreme Court of the United States to determine whether exercising jurisdiction would comport with notions of fair play and substantial justice. Those factors are:

“the burden on the defendant, the forum State’s interest in adjudicating the dispute, the plaintiff’s interest in obtaining convenient and effective relief, the interstate [and international] judicial system’s interest in obtaining the most efficient resolution of controversies.”

Karpeles argued that it would be too burdensome for him to fight this case, because he lives in Japan, and the Japanese government won’t let him leave. The Court said, in essence, too bad. Then Karpeles argued that Pennsylvania didn’t even have an interest in this case. The Court said sure it does “Pennsylvania has a manifest interest in providing effective means of redress when a foreign defendant reaches into the state and solicits its citizens.” Lastly, Karpeles argued that the Japanese civil rehabilitation proceedings is a better avenue for resolution of this case. The Court didn’t agree, and pointed to one of the sister cases that rejected that argument in part, because the chance of full recovery through the Japanese system was still speculative.

This case is going forward. Karpeles is now facing three class action lawsuits in multiple states around the country.

U.S. Commodity Futures Trading Commission v. Monex Credit Company, et al. (9th Cir., №18–55815, July 25, 2019) [SDP]

• CFTC sued defendant for $280 million, alleging violation of the Commodities Exchange Act (“CEA”) related to precious metals margin trading.
• Court of Appeals says that there wasn’t actual delivery of the commodity and the CEA applies to fraud claims without any allegation of manipulation.
• Precedent applies to crypto exchanges because bitcoin and other virtual currencies are commodities under the CEA.

Link to opinion: http://cdn.ca9.uscourts.gov/datastore/opinions/2019/07/25/18-55815.pdf

While Commodities Caselaw Minute doesn’t have quite the same ring to it as Crypto Caselaw Minute, U.S. laws governing commodities and, in particular, commodities futures trading are actually kinda important to understand from a “how does it all work” standpoint. Why? Well, for one thing, the Commodities Futures Trading Commission (“CFTC”) says that Bitcoin (and potentially other virtual currencies) are commodities under the Commodities Exchange Act (“CEA”).

This particular case addresses the Commodities Futures Trading Commission’s scope of power to regulate and enforce violations of the CEA. While the defendant here deals in precious metals, given the fact that Bitcoin is a commodity, the case squarely applies to the CFTC’s jurisdiction over crypto margin trading made available to U.S. customers. That’s why you’re reading about it here in Crypto Caselaw Minute.

First, some background to the law. The CEA is a Depression Era (1936 to be precise) law which has been amended many times and which governs the CFTC and its enforcement power. The CEA originally applied to commodities futures markets. Commodity has a really broad definition under the statute, and (in addition to Bitcoin) includes things as varied as sorghum, tallow, cows, and has a catch-all for ‘and all services, rights, and interests (except motion picture box office receipts, or any index, measure, value or data related to such receipts) in which contracts for future delivery are presently or in the future dealt in.”

The Court explains that under Dodd-Frank, which passed in 2010 in the wake of the 2008 financial crisis, the CEA was “extended to commodity transactions offered on a leveraged or margined basis as if they were futures trades.” There’s an exception for “leveraged retail commodity sales that result in ‘actual delivery’ within 28 days.” If you have actual delivery in 28 days, the CFTC’s jurisdiction isn’t triggered.

Monex Credit Company (“Monex”) is the defendant in this case. It sold precious metals and allowed investors to purchase commodities on margin through a program called “Atlas,” which allowed investors to pay part of the full price, with the rest financed by Monex. The CFTC said this was “an illegal and unregistered leveraged retail commodity transaction market” and sued Monex for $290 million for fraud in precious metals sales.

Monex argued that the CEA does not apply to retail commodities dealers who “actually deliver” the commodities in twenty-eight days. It also said that the CFTC didn’t authority over fraud claims without allegations of manipulation.

The trial court agree with both of Monex’ arguments and dismissed the case. The Court of Appeals disagreed with the trial court and reversed.

The Court explained Atlas as follows: “Once a customer opens an account, she may take open positions in precious metals. But the trading occurs ‘off exchange’ — that is, it does not happen on a regulated exchange or board of trade. Instead, Monex controls the platform, acts as the counterparty to every transaction, and sets the price for every trade.”

One of the risks with trading on margin is that if the value of the asset goes below a certain threshold, the account can be liquidated. Per the Court, “[o]ver the last eight years, Monex has made margin calls in more than 3,000 Atlas accounts and has force-liquidated at least 1,850.” At the same time, “Monex also retains sole discretion to liquidate trading positions without notice to the customer if equity drops too low, and it controls the price for every trade.” Also, commissions and fees came directly out of customer accounts (reducing their equity and thereby increasing liquidation risk).

Monex doesn’t actual “hand over any metals” and customers never actual control a commodity. The metals are kept in third party depositories and the only way customers can get them is they pay in full and either have the metals shipped to them or pick them up. “According the CFTC, Monex simply makes a ‘book entry’ when customers make trades — nothing more.”

The CFTC alleges the Atlas is designed for customers to lose money, that it isn’t “safe, secure or profitable,” as advertised, and has that Monex has been violated the CEA since 2011. In fact, it alleges, “Atlas is designed so that when customers lose, Monex gains.” Among other things, it pointed out that as the counterparty to every transaction, Monex benefits from “large price spreads at the customers expense.” In addition, it engaged in high pressure sales tactics while systematically understating the risks associated with trading.

The CFTC sued a number of Monex companies and two principals, alleging four separate CEA violations. The District Court said that three counts failed because Monex fell within the actual delivery exception and that the 4th failed because CFTC alleged only fraud, not fraud AND manipulation.

The Court of Appeals first examined the “actual delivery” exception. Monex argued that actual delivery took place when the commodities were delivered to third party depositories for the buyer’s benefit. The Court disagreed: “actual delivery requires some meaningful degree of possession or control by the customer.” While using a third party depository isn’t fatal to this exception, it didn’t work here because the metals were in a depository chosen by the broker, “never change hands, and are subject to the broker’s exclusive control, and customers have no substantial, non-contingent interest.” The fact that the commodity serves as collateral doesn’t change the analysis, according to the Court.

In short, “actual delivery [] unambiguously requires some degree of possession or control.” Transfer of title to the customer and delivery to a third party depository doesn’t satisfy this when it’s “simply a sham.” In this case, the customers had no contractual right to the metal, which was in Monex’s total control and could be liquidated by it at any time.

Monex’s second angle of attacks was that CFTC only alleged fraud, not fraud and manipulation. The relevant statutory language prohibits the use of “any manipulative or deceptive device.” The trial court said “or” should be read as conjunctive, meaning “and”. The Court of appeals disagreed — “or” means “or”, it reasoned; “[w]hen the word ‘or’ joins two terms, we apply a disjunctive reading.” Furthermore, this particular part of the CEA “is a mirror image of s 10(b) of the Securities Exchange Act which the Supreme Court has interpreted as a ‘catch-all clause.’” Bottom line — this Court says the CFTC doesn’t have to allege market manipulation under the section of the CEA raised here. Fraud is enough.

What does this all mean? Well, we have seen aggressive enforcement action by the CFTC in relation to Bitcoin and other virtual currencies in the past several years. What “actual delivery” means in connection with bitcoin margin trading has vexed others already. For example, the Bitfinex exchange ran afoul of the “actual delivery” requirement back in 2006 and entered in a consent orderover a very similar allegation:

Bitfinex’s retail-financed commodity transactions in bitcoin did not result in actual delivery to the Financing Recipients who traded on Bitfinex’s platform. Bitfinex did not transfer possession and control of any bitcoin to the Financing Recipients, unless and until all liens on the bitcoin were satisfied. Prior to satisfaction of the liens, the Financing Recipients’ bitcoins were held in an omnibus settlement wallet owned and controlled by Bitfinex, and to which Bitfinex held the private keys needed to access the wallet. Bitfinex’s accounting for individual customer interests in the bitcoin held in the omnibus settlement wallet in its own database was insufficient to constitute “actual delivery.” See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426, 52,428 (Aug. 23, 2013) (“book entry” purporting to show delivery insufficient). Similarly, when Bitfinex changed its model in August 2015 and January 2016, it retained control over the private keys to those wallets, and the Financing Recipients had no contractual relationship with the third party firm that established the wallets.

The CFTC subsequently issued a proposed interpretation regarding the meaning of actual delivery in connection with retail commodity transactions involving virtual currency, supplementing its 2013 guidance referenced in the quote above. While this area of law is not entirely settled, we now have more authority from a federal court about what “actual delivery means” and the authority is helpful additional precedent.

Enforcement activity involving fraud in connection with margin trading seems likely to be another continued angle of attack, particularly when one considers the description of the allegedly fraudulent activity CFTC alleges and the similarity to behavior by some who serve or have served U.S. customers. Assuming courts in other federal circuits agree that manipulation is not a requirement, this may lower the threshold for the CFTC to take action over crypto exchanges for past and present violations.