Summary

Following a three-day bench trial, US District Judge Jack B. Weinstein found in favor of the CFTC and ordered a permanent injunction banning Patrick K. McDonnell from dealing in virtual currency and ordering a judgment for $290,429.90 in restitution and $871,287.87 in civil penalties. 

Important to the virtual currency community at large is the court’s reiteration of its prior decisions, holding that pursuant to the CFTC’s “broad” anti-fraud authority “virtual currency may be regulated by the CFTC as a commodity.” It remains to be seen how courts will analyze the CFTC’s regulatory authority if conduct at issue is a more technical offense, such as a misstatement, omission or failure to register, rather than what appears to be a traditional boiler room fraud scheme alleged and proven in the McDonnell case.

In Depth

Following a bench trial of a pro se defendant accused of running a virtual currency boiler room, the Eastern District of New York found in favor of the US Commodity Futures Trading Commission (CFTC) and again held that “virtual currency may be regulated by the CFTC as a commodity.” CFTC v. McDonnell, No. 18-cv-361, ECF No. 172 (E.D.N.Y. Aug. 23, 2018). 

The CFTC charged Patrick K. McDonnell and his company, CabbageTech, for operating “a deceptive and fraudulent virtual currency scheme . . . for purported virtual currency trading advice” and “for virtual currency purchases and trading” which resulted in the misappropriation of retail investors’ funds. Id. at ¶ 25. In essence, the CFTC charged, and the court found, that Mr. McDonnell engaged in a “‘boiler room’ scheme defraud[ing] members of the public by conning them into believing they were paying for, and receiving, bona fide advice on investing in virtual currencies – that is to say: expert virtual currency trading advice from him and an imaginary team of advisors – and that he was making purchases and sales of virtual currencies using their assets on their behalf and for their benefit.” Id.¶ 15. The court held that “in reality, McDonnell never provided or intended to provide these services” and “instead, he ruthlessly misled customers and misappropriated their funds.” Id. ¶ 15. Mr. McDonnell has appeared pro sethroughout the various legal proceedings, despite the urging of the court that he retain counsel. Id. ¶ 10. After a three-day bench trial, the court determined that Mr. McDonnell engaged in fraud and ordered a permanent injunction banning him from dealing in virtual currency and ordering a judgment for $290,429.90 in restitution and $871,287.87 in civil penalties.

While Mr. McDonnell’s alleged scheme does not appear to be all that different from traditional securities and commodities fraud allegations, the court’s rulings on the CFTC’s regulatory authority—whether virtual currency constitutes a “commodity” under the Commodities Exchange Act—is important for the virtual currency industry at large.

In a previous decision issued in the same matter, the court held that “virtual currencies can be regulated by the CFTC as a commodity” and that it “fall[s] well-within the common definition of ‘commodity’ as well as the CEA’s definition of commodities.’” CFTC v. McDonnell, et al., 287 F. Supp. 3d 213, 228 (E.D.N.Y. Mar. 6, 2018); see also Rapidly Shifting Regulatory Landscape for Virtual Currencies | Market Participants: Stay Tuned (noting that in the McDonnell decision, the court identified nine options for which regulatory body should be tasked with regulating virtual currency: (1) none; (2) Department of Justice (DOJ); (3) CFTC; (4) SEC; (5); FinCEN; (6) IRS; (7) private exchanges; (8) state regulators; and (9) a combination of any of the above).

A motion for reconsideration was filed by Mr. McDonnell based on a decision in the United States District Court for the Central District of California, titled Commodity Futures Trading Commission v. Monex Credit Co., 311 F. Supp. 3d 1173, 1189 (C.D. Cal. May 1, 2018), which more narrowly defined the CFTC’s regulatory authority and dismissed a complaint. The Monex decision distinguished the prior decision in McDonnell holding that unlike the Monex plaintiffs, “[t]he pro se defendants in [McDonnell] did not raise the issue of whether § 6(c)(1) covered fraud in the absence of market manipulation.” Id. at 1189 n. 12. 

The Eastern District of New York denied Mr. McDonnell’s motion for reconsideration on procedural grounds, but also held that it “fully considered Monex and reaches a different conclusion.” CFTC v. McDonnell, No. 18-cv-361, 2018 US Dist. LEXIS 117939, at *4 (E.D.N.Y. July 16, 2018). The court “reaffirm[ed] its view that Title 7 U.S.C. § 9(1) gives the CFTC standing to exercise its enforcement power over the fraudulent schemes alleged in the complaint.” Id.

Following Mr. McDonnell’s bench trial, the court referenced its prior rulings and again held that the CFTC had the power to regulate virtual currency fraud schemes:

In extensive memoranda and orders, the court has found the Commission has standing and authority to bring this action for fraud involving virtual currencies (also referred to commercially as “cryptocurrencies,” “crypto,” “crypto coins,” “digital currencies,” and digital tokens.’” Virtual currency may be regulated by the CFTC as a commodity. CFTC’s broad statutory authority, Title 7 U.S.C. § 9(1), and regulatory authority, Title 17 C.F.R. § 180.1, extends to fraud or manipulation in the virtual currency derivatives market and its underlying spot market.

McDonnell, ECF No. 172, at ¶ 9 (internal citations omitted).

The decision appears to be limited to the CFTC’s regulation and prevention of fraud, rather than opining on the CFTC’s jurisdiction to regulate virtual currency generally. The court referred to its previous ruling: “holding that under the CFTC’s broad anti-fraud authority the Commission may exercise its enforcement power over fraud related to virtual currencies transacted in interstate commerce.” Id. ¶ 30. The court also noted: “[t]he CFTC was not seeking authority to regulate trading in virtual currencies” rather, “it was seeking only to stop and to prevent ongoing fraud.” Id. ¶ 31 (citing CNN, CFTC Does Not Regulate Retail Crypto Markets: Chairman Chris Giancarlo, Bitcoin Politics, ECF No. 156, July 26, 2018 (“The United States Commodity Futures Trading Commission (CFTC) Commissioner J. Christopher Giancarlo has stated that the agency’s [intent] is not to exercise regulatory jurisdiction over cryptocurrency trading markets and other cash markets, but to deal with fraud . . .”)).

Throughout the McDonnell decision, the court refers to Mr. McDonnell’s “boiler room” scheme as a “vicious fraud executed by Defendants to illegally deprive large numbers of investors in different states and countries of their assets by trickery, false statements, and misappropriation of funds.” Id. at 14. A scheme that the court held that the CFTC proved “beyond a reasonable doubt.” Id. The court devoted 45 pages of its decision to the testimony and related evidence of 4 victims of Mr. McConnell’s fraud.

It appears that the court found that Mr. McDonnell engaged in a pervasive scheme and the court repeatedly held that the CFTC’s “broad anti-fraud authority” covered such conduct. It remains to be seen how courts will analyze the CFTC’s regulatory authority if conduct at issue is a more technical offense, such as a misstatement, omission or failure to register, rather than what appears to be a traditional boiler room fraud scheme alleged and proven in the McDonnell case. The court’s opinion in McDonnell relies on the CFTC’s “broad anti-fraud authority” in determining that virtual currency fits the definition of a “commodity” with respect to the conduct at issue in that case. Whether virtual currency (or certain virtual currencies) will be considered a commodity for other purposes has yet to be determined.