The Commodities and Futures Exchange Commission (CFTC) announced it has filed enforcement actions against BitMex, related companies and individual officers including Arthur Hayes for illegally operating a derivatives exchange.
The formal charges include:
1) Execution of Futures Transactions on an Unregistered Board of Trade
2) Illegal Off-Exchange Commodity Options
3) Failure to Register as a Futures Commission Merchant
4) Failure to Register as a Designated Contract Market or Swap Execution Facility
5) Failure to Supervise and implement a Customer Information Program and KYC/AML procedures
The NY Attorney General (NYAG) in the Southern District also formally indicted the same individual officers criminally for:
1) failing to implement an anti-money laundering (AML) program under the Bank Secrecy Act
2) conspiracy to violate the Bank Secrecy Act
3) and for overt acts allowing US residents to use their platform
Could there be constitutional challenges to some of the charges?
US Gov, BitMex and The Constitution
So what does this all mean for cryptocurrency supporters and startup founders? First of all these are just charges that need proper due process and judicial proceedings to resolve. Oftentimes regulators like to make an example out of high-profile and successful individuals such as Arther Hayes and their businesses. Most often parties settle and the settlement amount is usually dependent on how strong the regulator’s case is. Most startup founders in the cryptocurrency industry have known that they’ve been operating in gray areas of laws and regulation for many years and many have expected formal challenges from regulators to get more legal clarity. The facts and legal considerations for each case vary greatly so everyone should be careful to draw broad conclusions based on the outcome of this particular case or any other, especially if you’re relying on media headlines to inform you about the law. The substance of the law is often nuanced. District court opinions serve as a good reference, but district court judges do make errors and hence circuit court appellate opinions and ultimately the Supreme Court opinions are the most important opinions to consider. Unconstitutional statutes can and do remain as law for decades without ever being challenged.
While protecting consumers is worthwhile, many US regulations stifle innovation. Hence most companies avoid doing business in the US due to the strict and aggressive regulatory bodies such as the CFTC and SEC. Furthermore while the US culture is often known for individual freedom and is buttressed by its common law judicial system and the US Constitution, many statutes that the US legislature pass seem to be intended primarily to enhance government power over people and for capital controls. The Bank Secrecy Act seems to be a prime example of government overreach that hide behind the facade of combating terrorism and money-laundering. Government control over money is another example. Bitcoin and cryptocurrencies are a solution to the latter and there is no reason to believe that in this new cryptocurrency monetary system that people should simply comply with the same old rules that will limit the sovereignty and power of Bitcoin and cryptocurrencies. Hence to defend against excessive government overreach and regulations, it is important to look deeper into US law and the Constitution for defense.
CFTC civil complaint
The CFTC has a standard regulatory framework for commodity businesses for futures and options and those statutes may be more difficult to challenge. Some of the issues that can be raised by the defense is:
1) Is Bitcoin really a commodity? A virtual currency? Money? What are the legal precedents, case law, opinions or rulings on the matter?
Bitcoin and cryptocurrencies are based on new technology and hence there should be some leniency about regulation. One recent ruling CFTC v. McDonnell (2018) implicated Bitcoin as a commodity and hence there could be an argument that BitMex did not register with the CFTC based on the lack of clarity of Bitcoin’s classification as a commodity before then. BitMex can claim they have no scienter, meaning they did not know their actions were wrong and did not commit any fraudulent activities.
2) The doctrine of laches in civil courts of equity typically suggests that plaintiffs should not delay too long before filing a complaint once they believe wrongdoing has occurred. In this case the CFTC plaintiff should have filed a complaint many years earlier than they did. Regulators as a standard practice should issue warnings to any companies they feel are non-compliant.
3) Does the US have jurisdiction?
BitMex is incorporated in Seychelles. The CFTC and NYAG claims to have jurisdiction over BitMex and individuals who were operating out of Manhattan sometime around 2017 to early 2019 and hence there may be a nexus of business within the US. However a jurisdictional defense is precisely why you incorporate offshore and why company funds may likely be very protected.
4) BitMex can claim that even without KYC/AML they took reasonable efforts to prevent US citizens from using their platform.
NYAG criminal complaint
5) What specific statutes do the NYAG claim BitMex and company individuals violated?
So far the Bank Secrecy indictment refers to 31 U.S. Code § 5318 and 5322 & 31 CFR 1026.210 and 220.
-31 U.S. Code § 5318 – covers KYC/AML procedures
-31 U.S. Code § 5322 – covers criminal penalties for ‘willful’ violations
-31 CFR § 1026.220 – covers AML requirements for futures commission merchants
-31 CFR § 1026.220 – covers KYC requirements for futures commission merchants
6) Are these statutes constitutional?
Not all laws are constitutional. In fact many laws are not constitutional, yet they never get challenged in the Supreme Court. The Bank Secrecy Act of 1970 was challenged soon after its enactment by banks, depositors and the ACLU and various cases were consolidated in California Bankers Assn. v. Shultz, 416 U.S. 21 (1974). The overall Supreme Court opinion was that bank depositors didn’t have constitutional standing against the government’s Bank Secrecy Act because the requirements were against institutions and depositors would not be harmed by mere recordkeeping. Banks did not have the same constitutional protections as corporations and the court ruled that the recordkeeping was a reasonable demand. However there have been a series of other anti-money laundering legislation enacted since 1970 that may be open for constitutional challenge.
3) 31 U.S. Code § 5322 require that defendants willfully violate the statute. The ‘willfullness’ requirement seems like a high hurdle for the NYAG especially considering the uncertainty of Bitcoin commodity classification, their offshore jurisdiction, the fact they were not even registered with the CFTC and the fact that BitMex did seem to place restrictions on US citizens. Although not a perfect example, a good case precedent to refer to is Ratzlaf v. United States, 510 U.S. 135 (1994) where the Supreme Court overturned an appeal and established a higher hurdle for the US government to prove a defendant’s ‘willfullness’. Lastly it seems incredibly unfair to criminally charge individuals without first resolving the registration issue with the CFTC. It would seem more logical to only be able to file criminal charges after a financial entity is warned about a failure to register first and is given the opportunity to rectify registration violations with civil penalties before these Bank Secrecy Act criminal penalties even apply.
4) Finally if you want to think outside the box, the entirety of the KYC/AML regulations seem to fall under the ‘Money’ section of US Code (31 U.S. Code SUBTITLE IV—MONEY). This seems very likely not to be part of the Interstate Commerce Clause covered under Title 15 that might give the US government broad powers. Hence the only other enumerated power these regulations can fall under is Article I, Section 8 Clause 5 of the US Constitution: “To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;” There is no mention of regulating the recording of monetary transactions. One can even challenge the constitutionality of the Federal Reserve system and fiat money. Hence the entire ‘Money Transaction’ section of the US Code and CFR might be considered null and void and outside the authority of the government if constitutionally challenged.
Although there may be paths to make constitutional challenges against government overreach, the most likely and conservative path is for Hayes and BitMex to settle. Government agencies may fear challenges to large sections of statute and power they’ve been accustomed to for decades and with more originalist Supreme Court justices like Amy Coney Barrett on the bench there is more opportunity to strike down unconstitutional laws. Hence crytocurrency advocates should promote individual rights and originalist philosophy and take advantage of the current US judicial system.
Overall from a more practical approach there are some ideas that cryptocurrency founders might consider if the regulatory compliance costs are too much of a burden for bootstrapping your startup:
1) Incorporate outside the US. The US is not a favorable jurisdiction for a crypto business so it is best to incorporate outside if you are concerned with the CFTC or SEC.
2) Avoiding US customers and focus on other countries.
3) Avoid having an office location in the US. There may be flexibility with remote workers in US, but having an office in the US is not recommended especially if you’re trying to take advantage of an offshore jurisdiction.
4) Consider creating a decentralized organization with no official legal entity. Decentralized autonomous organizations (DAO) and companies (DAC) are more resilient against regulation because you can avoid liabilities around custody and much of the business activity is peer to peer. It may be that CFTC rules don’t apply if a company does not hold custody of customer funds.