CFTC Charges Digital Asset Exchange And Its Founder With Violating The Commodity Exchange Act And Commission Regulations
On March 27, 2023, the Commodity Futures Trading Commission (“CFTC”) filed a civil enforcement action against three entities that operate a digital asset exchange (the “Company”) and its Founder and Chief Executive Officer (collectively “Defendants”) for willful violation of the Commodity Exchange Act (“CEA”) and CFTC regulations. Further, the CFTC charged the Company’s Former Chief Compliance Officer with aiding and abetting these violations. See Complaint, Commodity Futures Trading Comm’n v. Zhao, et al., Civil Action No. 1:23-cv-01887 (N.D. Ill. Mar. 27, 2023).
According to the CFTC, the Company “operates the world’s largest centralized digital asset exchange” and emerged “through an opaque web of corporate entities.” Compl. at ¶ 1. The CFTC alleged that much of the Company’s trading volume and profitability stems from U.S.‑based customers and that Defendants are allegedly targeting U.S.-based customers. The CFTC claims that, though Defendants may publicly state otherwise, the CEO has privately admitted that “20% to 30% of [the Company’s] traffic comes from the US.” Id. at ¶ 107. Further, the CFTC points to a July 2019 financial document that “attributes approximately 22% of the Company’s revenue for June 2019 to U.S. customers.” Id. at ¶ 107. Based on this and similar factual allegations, the CFTC asserts that Defendants knew that the Company was subject to U.S. registration and regulatory requirements.
Specifically, the CFTC claims that Defendants offered and dealt in off-exchange retail commodity transactions for future delivery with U.S.-based customers from July 2019 to the present, which the CFTC alleges must be executed on a regulated futures exchange. See Compl. at ¶¶ 30, 188. According to the CFTC, Defendants deployed a strategy of regulatory arbitrage by purposefully availing themselves of laws in a favorable jurisdiction to avoid less favorable U.S. regulations. In furtherance of this effort, the CFTC alleges that Defendants hid the identities and locations of entities operating the trading platform—going so far as to highlight in its complaint that the CEO claims the Company’s headquarters is “wherever he is located at any point in time” and that “[the Company] conducts its operations through various entities incorporated in numerous jurisdictions to ‘keep countries clean of [violations of law]’ by ‘not landing .com anywhere. This is the main reason .com does not land anywhere.’” Id. at ¶ 5. Based on this alleged conduct, the CFTC charged Defendants with violating Section 4(a) of the CEA, 7 U.S.C. § 6(a), and Regulation 1.6, 17 C.F.R. § 1.6 (2022), or, in the alternative, the CFTC charged Defendants with violations of Section 4(b) of the CEA, 7 U.S.C. § 6(b), and Regulation 48.3, 17 C.F.R. 48.3 (2022).
Along with the alleged purposeful obfuscation of the entity’s location, the CFTC claims that the CEA requires, absent certain exemptions, that commodity derivative transactions are conducted on CFTC-designated or -registered exchanges. Due to this requirement, the CFTC alleges that Defendants failed to register commodity options it dealt with on any registered board of trade and failed to seek registration as an exempt foreign board of trade. Thus, the CFTC charged Defendants with violations of Section 4c(b) of the CEA, 7 U.S.C. § 6c(b), and Regulation 32.2, 17 C.F.R. § 32.2 (2022). Similarly, the CFTC stated that Defendants should have registered as a Futures Commission Merchant and a Designated Contract Market or Swap Execution Facility. Due to this alleged failure, the CFTC charged Defendants with violating Sections 4d and 5h(a)(1) of the CEA, 7 U.S.C. §§ 6(d), 7b-3(1), and Regulation 37.3(a)(1), 17 C.F.R. § 37.3(a)(1) (2022).
The CFTC also claims that Defendants failed to adequately supervise and implement appropriate policies and procedures to prevent money laundering and funding of terrorism. The CFTC’s complaint states that, in an effort to circumvent restrictions on U.S.-based customers, Defendants allegedly instructed U.S. customers to obscure their location by using virtual private networks (“VPNs”), not submitting proof of identity, and opening Company accounts under shell companies. To support this allegation, the CFTC’s claims highlighted that the Company’s VPN guide, which stated that “you might want to use a VPN to unlock sites that are restricted in your country,” effectively taught “U.S. customers to circumvent [the Company’s] IP address-based compliance controls.” Compl. at ¶¶ 117-18. Further, the CFTC claims that Defendants not only taught customers how to bypass restrictions, but also claims that the Company’s own Money Laundering Reporting Officer agreed that “we see the bad, but we close [two] eyes.” Id. at 104.
In particular, the CFTC claims that Defendants (i) failed to implement an effective Customer Information Program; (ii) failed to implement effective Know-Your-Customer procedures; (iii) failed to implement effective Anti-Money Laundering procedures; (iv) failed to ensure that its partners, officers, employees, and agents, handled all commodity interest accounts at the Company in a lawful and appropriate manner; (v) instructed customers to evade compliance controls; and (vi) intentionally destroyed documents related to illegal conduct. See Compl. at ¶ 219. Due to its alleged failure in supervising and implementing supervisory programs and procedures, the CFTC charged Defendants with violations of Regulations 166.3 and 42.2, 17 C.F.R. §§ 166.3, 42.2 (2022).
The CFTC seeks disgorgement, rescission of contracts and agreements, civil monetary penalties, restitution, payment of costs and fees, permanent trading and registration bans, and a permanent injunction against further CEA and CFTC regulation violations. This civil enforcement action against a cryptocurrency platform and officers is the latest in a string of enforcement actions by the CFTC and the SEC in the digital asset space. CFTC Chairman Rostin Behnam commented on Defendants’ ephemeral location by saying that “[t]oday’s enforcement action demonstrates there is no location, or claimed lack of location, which will prevent the CFTC from protecting American investors.… This should be a warning to anyone in the digital asset world that the CFTC will not tolerate willful avoidance of U.S. law.”