March 26, 2020
by Katherine Cooper

            On March 24, 2020, the Commodity Futures Trading Commission (“CFTC”) announced that it had unanimously adopted final interpretative guidance (“Final Interpretation”) regarding the term “actual delivery” as it is used in the Commodity Exchange Act (“CEA”) provisions governing retail commodity transactions in the context of virtual currencies.[1]  Section 2(c)(2)(D) of the CEA[2] prohibits the sale of a commodity on margin or with leverage to retail customers unless the transaction results in “actual delivery” within 28 days.  The CFTC issued final interpretative guidance in 2013 about the meaning of “actual delivery” in the context of commodity transactions generally.[3]  In 2017, the CFTC proposed interpretative guidance regarding the application of the term “actual delivery” specifically in the context of virtual currency transactions.[4]  In light of the path leading to the term “actual delivery” finding its way into the CEA and the CFTC’s prior attempts in apply it to virtual currencies, the Final Interpretation delivers a well-balanced approach to interpreting “actual delivery.”

            Since its founding 45 years ago, the CFTC has struggled at times to enforce CEA Section 4(a)’s requirement that all futures contracts trade on a registered exchange.  Much of the off-exchange activity involved fraudulent futures-like investment schemes preying upon unsophisticated investors. The CFTC had some success starting with CFTC v. Co Petro Marketing Group, Incorporated[5] in 1982 where the Ninth Circuit accepted the CFTC’s argument that if under the totality of the circumstances an off-exchange contract functioned like a futures contract and the parties’ intentions were that the contract was to work like a futures contract, it was an illegal, off-exchange futures contract regardless of how the contract was drafted.

            The Co Petro totality of the circumstances test came under question nearly 20 years later in Nagel v. ADM Investor Services, Incorporated,[6] where the Seventh Circuit criticized the uncertainty created by the Co Petro totality of the circumstances test. 

[T]he ‘totality of the circumstances’ approach invites criticism as placing a cloud over forward contracts by placing them at risk of being reclassified as futures contracts traded off-exchange and therefore illegal.[7]

However, to avoid overruling its earlier acceptance of Co Petro’s intent-based approach, the court limited the “totality of the circumstances” to what was contained within the four corners of the contract. 

            Eight years later, however, the Seventh Circuit delivered the coup de grace to Co Petro in CFTC v. Zelener.[8]  It noted that Co Petro’s totality of the circumstances test turned largely on the parties’ conduct after they had entered into the contract.  The court found that unacceptable:

It is essential to know beforehand whether a contract is a futures or a forward. . . . Nothing is worse than an approach that asks what the parties “intended” or that scrutinizes the percentage of contracts that led to delivery ex post.  [The Co Petro approach] leave[s] people adrift and make[s] it difficult, if not impossible, for dealers . . . to know their legal duties in advance. [9]

The Zelener decision left the CFTC without an arrow in its quiver to combat off-exchange fraud involving futures-like investment schemes targeted at unsophisticated, retail investors.  In 2010, Dodd-Frank provided a “fix” by adding Section 2(c)(2)(D) to the CEA prohibiting the sale of commodities on margin to retail investors unless “actual delivery” occurs in 28 days.

            Fast forward to 2016, the CFTC entered into a consent order in In re BFXNA d/b/a Bitfinex,[10] finding that Bitfinex had violated Section 2(c)(2)(D) by selling Bitcoin on margin to retail customers but not giving the customers control over the wallet in which the Bitcoins purchased on margin were stored, and as such, “actual delivery” had not occurred.  After Bitfinex, the digital asset community was clamoring for CFTC guidance and in late 2017 the CFTC proposed interpretative guidance regarding “actual delivery” in the context of virtual currency transactions.

            The 2017 proposed guidance adopted much of the fairly inflexible approaches the CFTC adopted in its 2013 final guidance on “actual delivery” in commodity transactions in general.  The proposed guidance, like the 2013 final guidance, held that if the virtual currency sold on margin remained in a depository controlled by, or affiliated with, the seller after 28 days, actual delivery will not have occurred.  Likewise, if the transfer of the virtual currency only occurs via a book-entry on the seller’s books and records, actual delivery will not have occurred.  And finally, if positions are closed out and re-established, i.e., “rolled,” actual delivery has not occurred.[11]

            The CFTC’s Final Interpretation has softened some of the inflexibility in its original proposal.  It offers an overarching principle on which it would determine whether “actual delivery” has occurred which is “when a customer achieves both possession and control of the virtual currency underlying the transaction.”[12]  This steps back from a focus in the proposed interpretation on whether the customer possessed “a particular key or blockchain address.”[13]  Another important factor the CFTC identifies is whether the customer can use the virtual currency freely in commerce as a medium of exchange.  As a result, “the presence of a lien, debt obligation or other security interest on virtual currency generally makes impractical for the customer to use the virtual currency freely in commerce as a medium of exchange, thus frustrating actual delivery.”[14]

            Recognizing that the digital asset business had developed and that certain service providers were regulated in various ways, the CFTC dropped its absolute ban on virtual currency being held at a depository affiliated with the seller.  For such an affiliate relationship not to prevent actual delivery to being found to have occurred, the affiliate must be a “financial institution” as defined in the CEA, be in a separate line of business than the seller, be a separate legal entity, predominately operate for the purpose of providing custodial services, be appropriately licensed, offer the customer the ability to utilize cold storage of the virtual currency and be contractually authorized by the customer to act as its agent.[15]

            Another important flexibility included in the Final Interpretation allows the seller to maintain liens and control over collateral other than the virtual currency bought on margin.  This is an acceptance of the practices of certain market participants and does allow them the means to legally offer the sale of virtual currency on margin to retail investors.[16]

            The Final Interpretation shows welcome increased flexibility and responsiveness to market participants’ comments and concerns.  At the same time, the Final Interpretation is careful to make sure the CFTC has the tools it needs to continue its fight against unscrupulous fraudsters selling futures-like investments to the most vulnerable.  It is thoughtful work issued in the midst of a global pandemic.  Well done.

 

[1] Retail Commodity Transactions Involving Certain Digital Assets, RIN Number 3038-AE62 (CFTC Mar. 24, 2020) (“Final Interpretation”), available at: https://cftc.gov/PressRoom/PressReleases/8139-20

[2]  7 U.S.C. § 2(c)(2)(D).

[3] Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426 (CFTC Aug. 23, 2013).

[4] Retail Commodity Transactions Involving Virtual Currency, 82 Fed. Reg. 60,335 (CFTC Dec. 20, 2017).

[5] 680 F.2d 573 (9th Cir. 1982).

[6] 217 F.3d 436 (7th Cir. 2000).

[7] 217 F.3d at 441.

[8] 373 F.3d 861 (7th Cir. 2004).

[9] 373 F.3d at 864.

[10] CFTC Docket No. 16-19 (June 2, 2016).

[11] 82 Fed. Reg. at 60340; cf. 78 Fed. Reg. at 52428.

[12] Final Interpretation at 15.

[14] Id. at 25.

[15] Id. at 19.

[16] Id. at 34 n.172.

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