East Asia is reportedly the world’s leading marketplace for virtual currency with three of the largest exchanges based in China, Japan, and South Korea. China-based exchanges alone reportedly account for more than 90% of the global trading volume in virtual currency.
These virtual currency businesses may be surprised to learn that they may be exposed to possible government enforcement actions and private litigation in the US based on conduct taking place in their home jurisdictions.
The US government has recently taken aggressive steps to police the global virtual currency markets, taking a view that, in some circumstances, virtual currencies can constitute “securities” and “commodities” subject to enforcement and prosecution under US law. These recent actions open a Pandora’s box of possible legal consequences for virtual currency businesses operating in East Asia.
Enforcement actions in the US
The US government has been flexing its muscles to police virtual currency markets around the world, including by bringing a number of recent actions against businesses in East Asia and others parts of the world.
In 2016, a US government body brought an enforcement action against Hong Kong-based virtual currency exchange Bitfinex for failing to register with the government body. As recently as July 2017, US prosecutors fined Russia-based virtual currency exchange BTC-e US$110 million for violating US anti-money laundering laws.
These enforcement actions against virtual currency exchanges around the world are predicated on conduct occurring outside the US that has an effect within the US. And while the US government’s legal reach may not necessarily be valid, and is open to dispute, that may be little comfort to companies and individuals charged with illegal activity in the US.
Three US enforcement bodies are leading the competition to become the top regulator in the global virtual currency space.
Securities and Exchange Commission
The US Securities and Exchange Commission (SEC) has stated unequivocally that it intends to regulate many new virtual currencies as “securities” under US law. In a report published in July 2017, the SEC indicated that virtual currency offerings (or “initial coin offerings” that exchange virtual currency for working capital) that implicate US investors will in most cases be considered “securities” offerings subject to SEC enforcement jurisdiction.
This classification of virtual currencies as securities creates important legal consequences for virtual currency businesses in East Asia and around the world, including potentially virtual currency issuers, currency “miners”, investors, traders, exchanges, investment advisers and brokers.
The categorization could impose the full body of US securities laws on many virtual currency businesses and forbid a host of conduct for the first time, such as insider trading, market manipulation, or securities fraud in virtual currencies.
Take the example of Bitfinex: “Spoofing” and “wash trading” activity was recently reported on the Hong Kong-based exchange. “Spoofing” involves placing a large number of sell or buy orders to drive the market price in a particular direction with the intent of cancelling those orders before they are executed.
“Wash trading” involves trading with oneself to give a misleading appearance of market activity. These practices are generally considered illegal under US securities and commodities laws but are currently unregulated in virtual currency markets.
That could all be about to change. There is a strong possibility that this and other types of forbidden conduct when “securities” are involved could be subject to enforcement actions by the SEC.
Commodity Futures Trading Commission
The US Commodity Futures Trading Commission (CFTC) has also firmly planted its flag in the virtual currency space. In June 2016, the CFTC brought an enforcement action against the Bitfinex exchange for violating US law by allowing virtual currencies to be traded on a leveraged basis without registering with the CFTC.
The CFTC adopted a view that virtual currencies constitute “commodities” governed by US commodities laws and, therefore, Bitfinex was required to register. Bitfinex co-operated with the CFTC, but ultimately paid a US$75,000 fine.
The CFTC also recently took enforcement action against another virtual currency exchange, TeraExchange, for engaging in prohibited trading practices in commodities derivatives. That action was also predicated on an interpretation of US commodities laws to cover virtual currencies.
In an important signal of future scrutiny and oversight in this space, the CFTC has just approved the first Bitcoin derivative trading in the US. The CFTC may now try to assert authority over trading practices in underlying digital currency markets that provide reference prices for newly approved derivatives products, or other markets that affect these prices through arbitrage.
The Internal Revenue Service
Finally, virtual currency operators around the world may be exposed to information requests and possible enforcement actions by the US Internal Revenue Service (IRS) for facilitating transactions subject to US taxation.
The IRS is in the midst of a campaign to catch tax evaders who failed to report capital gains on the immense appreciation in Bitcoin from 2013 to 2015. As a part of that campaign, in November 2016, it subpoenaed client and transaction records from virtual currency exchange Coinbase. East Asia-based businesses may well face similar requests for records related to US taxpayers.
Private litigation in the US
East Asia-based companies that deal with US counterparties can also be sued in the US by private parties – for example, aggrieved investors – under US securities and commodities laws, or for common law claims such as fraud, negligence or breach of fiduciary duty.
Litigants in the US have broad discovery powers that can be weaponized and wreak havoc on businesses that must respond to onerous requests or face possible contempt of court sanctions or even default judgment in US courts. Recent legislation gives plaintiffs powerful new remedies, such as rescission of trades or, in some cases, punitive damages. It is doubtful that virtual currency operators can completely eliminate these risks by using exclusive non-US choice-of-forum or choice-of-law clauses in terms of service or client contracts.
Government inquiries or private suits
Companies confronting potential enforcement actions or disputes in the US should consider the following when formulating a defence strategy at the outset of any matter:
- Challenges to application of securities and commodities laws in the first instance. The SEC’s and the CFTC’s categorization of virtual currencies as securities and commodities for certain purposes has not been tested in court. These positions can be challenged. There are good arguments that the CFTC does not have statutory jurisdiction over virtual currency traders, and that virtual currencies do not meet the legal standard to constitute securities under US law. Companies should consider arguments that the specific facts of their case are not covered by US securities and commodities laws to start with.
- Statutory defences under US securities and commodities laws. Virtual currency businesses should also consider defences available under the US securities and commodities statutes. In the event that a challenge to application of US securities and commodities laws fails, these statutory defences can create an important line of defence against both government enforcement and private litigation.
- Challenges to personal jurisdiction. Important potential defences may also be available for non-US businesses, based in East Asia or elsewhere outside of the US, to challenge assertions of personal jurisdiction over them. Virtual currency businesses should analyze and consider these defence options when formulating a response strategy.
- Challenges to discovery requests. Document requests (by way of judicial or legal assistance) from the US government or private parties may also be subject to legal defences and objections under US procedure, such as the US attorney-client privilege or other legal privileges including those recognized under local law. Before producing documents, information or testimony to the US government or US civil litigants, virtual currency operators should carefully assess what a request requires and what legal defences or privileges may apply under local or US law.
East Asia-based virtual currency companies are exposed to overlapping legal risks in their home jurisdictions, and in the US, from US federal agencies, US state regulatory bodies and private litigants.
The penalties can be severe, including disgorgement of profits, injunctions to prohibit further conduct, revocation of registrations or licences, and special remedies such as periodic audits, or monitorships, or supervisory arrangements.
Companies must closely monitor the rapidly changing legal landscape in this space so that, should a legal issue arise, they can properly consider potential options and mount an aggressive defence with the advice of experienced cross-border counsel.
John Han is a principal at Kobre & Kim’s Hong Kong office and Benjamin Sauter is a principal at the firm’s New York office. Nan Wang, an associate at the Hong Kong office, also contributed to the article.