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Defining the boundaries of commodity regulation: Monex v. CFTC (2017)

By Michael R. Berry

Overview

When is a cash contract a futures contract?

Defining where the Commodity Futures Trading Commission’s remit begins, and ends is an important jurisdictional question. On June 29, 2020, the United States Supreme Court denied Monex Deposit Company’s petition for a writ of certiorari in the case of Monex Deposit Company versus the Commodity Futures Trading Commission. The petition was filed with the Supreme Court after the Ninth Circuit Court’s July 2019 decision to overturn a District Court’s Order allowing Monex’s Motion to Dismiss.

On September 6, 2017, the Commodity Futures Trading Commission (CFTC) filed a complaint against Monex Deposit Company, Monex Credit Company, Newport Services Corporation, Louis Carabini, and Michael Carabini (Monex) alleging fraud and operating an unregistered exchange.

The CFTC filed this lawsuit seeking an injunction and restitution against Monex alleging violations of:

  • (1) CEA § 4(a), 7 U.S.C. § 6(a), for engaging in off-exchange transactions;
  • (2) CEA § 4b(a)(2)(A) and (C), 7 U.S.C. § 6b(a)(2)(A) and (C), for fraud;
  • (3) CEA § 6(c)(1), 7 U.S.C. § 9(1), 17 CFR § 180.1(a)(1)–(3), for fraud; and
  • (4) CEA § 4d, 7 U.S.C. § 6d(a)(1), for failing to register.

The CFTC alleges that a fraud of $290 million occurred. The CFTC seeks restitution, rescission, disgorgement (see here), civil monetary penalties, and such other equitable relief.

The MONEX Brief

The folks over at Monex see things a bit differently. In their brief to the Ninth Circuit Monex has claimed that “The CFTC’s violence to the fundamental structure of CEA and its history,” makes the CFTC’s pursuit of this matter beyond CFTC’s jurisdiction. Monex also alleged the CFTC has engaged “………, in a series of cases including this one, asserted litigation positions to achieve indirectly what Congress denied it directly.”

At issue is the definition of the term “actual delivery”. Delivery terms and definitions have been at the heart of several significant decisions related to the CFTC’s jurisdiction e.g. The Brent Interpretation. Unfortunately, the term was not defined in the CEA. And again, Dodd-Frank rears its head and has implications in this case. In 2011 Congress passed Dodd-Frank that amended parts of the Commodity Exchange Act (CEA),  “To this end, Congress gave the CFTC express authority over retail transactions involving leverage, margin or financing, 7 U.S.C. §2(c)(2)(D)(i), while simultaneously excepting from the CEA and the CFTC’s authority any such transactions, “that result[] in actual delivery within 28 days.” Id. §2(c)(2)(D)(ii)(III)(aa).” That text gave birth to the term the 28-day exemption.

How the CFTC addresses the 28-day exemption that Monex is relying upon is based on how the CFTC characterizes the Monex transactions. “The CFTC alleges that, under this definition, Monex’s delivery is a “sham” because customer accounts are subject to margin calls and possible liquidation, and customers do not have personal possession and control of collateralized metals before loan repayment.” It is the CFTC’s contention that transferring title while having credit encumbrances constructed the way Monex did, does not meet the definition of actual delivery.

Monex also attacked the CFTC’s interpretation of the anti-fraud authorities granted to the commission in the wake of Dodd-Frank. If the transactions underlying this matter do not come within the regulatory CFTC authority which, if any the regulatory infractions apply? Do both fraud allegations apply?

The Ninth Circuit.

“A two-letter conjunction and a two-word phrase decide this case.” – The Ninth Circuit Court

The issue before the Circuit Court was to determine if the District Court’s Order in support of Monex’s Motion to Dismiss was to stand. The Court analyzed two aspects of the case, The Actual Delivery Exception and whether “any manipulative or deceptive device” allows stand-alone fraud claims or requires fraud-based manipulation.”

“First, the CEA uses “delivery” in § 1a(27), which we have said “cannot be satisfied by the simple device of a transfer of title.” CFTC v. Noble Metals Int’l, Inc., 67 F.3d 766, 773 (9th Cir. 1995).”

As it relates to the delivery exception in the Monex matter the Ninth Circuit Court stated; “It is possible for this exception to be satisfied when the commodity sits in a third-party depository, but not when, as here, metals are in the broker’s chosen depository, never exchange hands, and are subject to the broker’s exclusive control, and customers have no substantial, non-contingent interests.” This construct, the court determined did not constitute a meaningful degree of possession for the customer.

Also, according to Monex, Dodd-Frank extended the CFTC’s power only to fraud-based manipulation claims, so stand-alone fraud claims—without allegations of manipulation—fail as a matter of law. Monex was not alleged to have engaged into manipulative behavior. The court was to determine if that allegation of fraud was valid absent any allegation of manipulation.

As for the fraud-based manipulation aspect the case the District Court held that “any manipulative or deceptive device” in § 6(c)(1) requires manipulative and fraudulent behavior. The Ninth Circuit Court overturned stating, “…the district court held that “or” really meant “and.” We disagree.”

Ultimately the Ninth Circuit Court found the CFTC may sue for fraudulently deceptive activity, regardless of whether it was also manipulative.

Analysis

The CFTC’s charges emanate from the acts and activities of the Monex defendants. The CFTC claims that since 2011 Monex has operated an unlicensed trading platform, “Monex operates its own unregulated trading platform (Atlas), allowing customers to place futures-like trades to speculate on price movements in precious metals, with Monex acting as the counterparty to every transaction.” As such the contracts fall under the CEA.

The CFTC Complaint goes on to say, “During the review period, approximately 90% of leveraged Atlas account customers realized losses (including losses from trading, interest charges, and other fees). for all leveraged Atlas customer accounts during the relevant period were at least $290 million. Including unrealized profit or loss on open trading positions increases the loss amount to more than $325 million for the review period. A substantial portion of these losses were caused by fees and charges imposed by Monex.”

 

Conclusion

The CFTC is pushing the definition boundaries of the term actual delivery. The Ninth Circuit made it clear regarding the limitations of its rulings, “In bill drafting, as in life, little things often make big differences. Here, three words stand between dismissal and discovery. Although Monex contends that no fraud occurred, we must, at this point, accept as true the CFTC’s well-pleaded complaint to the contrary. And because the CFTC’s claims are plausible, this lawsuit should continue.” The CFTC has alleged the Monex deliveries “sham” transactions and therefore not actual deliveries.

Back to a court of law for that determination. The Motion to Dismiss was not upheld. This battle to define the boundaries continues.