Crypto Investigation Tests Limits of NY AG’s Authority

New York Law Journal

The New York Office of Attorney General (OAG) is battling one of the largest global cryptocurrency exchanges (BitFinex) and one of the most prominent “stablecoin” issuers (Tether) in a proceeding that may test the limits of the OAG’s expansive authority to prosecute securities and commodities fraud under the Martin Act. The matter has potential ramifications for many cryptocurrency businesses, especially those that take steps to avoid New York and view themselves as outside the reach of the OAG’s jurisdiction. The proceeding is before New York Supreme Court Justice Joel Cohen, styled In the Matter of the Inquiry of Letitia James, Attorney General of the State of New York v. iFINEX INC., et al., No. 450545/2019 (Sup. Ct. N.Y. County).

Bitfinex claims to be the world’s largest exchange by volume for trading Bitcoin against the U.S. dollar. Companies that share ownership with Bitfinex also issue digital assets known as “tethers” to facilitate trading on Bitfinex and other platforms (the companies that issue tethers are also collectively referred to as Tether). Tethers are a form of “stablecoin”—a term derived from the fact that their value is pegged to traditional currency. Tether pegs the value of U.S. dollar tethers (USDT) to the dollar by representing that each USDT is redeemable for one dollar. Initially, Bitfinex and Tether also represented that USDT were backed “one-to-one” by currency held in reserves. As of early May 2019, there were approximately $2.8 billion in U.S. dollar tethers (USDT) in circulation, and it continues to trade near par to the dollar. Dkt No. 52.

Bitfinex began distancing itself from New York in 2017. Its terms of service barred New York customers in January 2017, extended that ban to all U.S. individual customers in August 2017 and to U.S. entity customers as of August 2018. Bitfinex also claims to conduct screening to remove violators.

The OAG Investigation

In 2018, the OAG launched a Virtual Markets Integrity Initiative, culminating in a September 2018 report that catalogues a variety of concerns about conduct, controls, and security on cryptocurrency exchanges. Nine of the 13 platforms contacted by the OAG, including Bitfinex, voluntarily participated in the initiative.

In late February 2019, Tether stopped claiming that it held one-to-one reserves of traditional currency and disclosed that the reserves backing tethers “may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities” and warned that those reserves “are subject to the risk of default, insolvency, inability to collect, and illiquidity.” Dkt. No. 52 at 8; Dkt. No. 56 at 3. Around the same time, Bitfinex and Tether’s counsel advised the OAG that they were “contemplating extending a ‘line of credit’ on the Tether reserves to Bitfinex in the amount of $600 to $700 million… .” Dkt. No. 56 at 5. According to the OAG, Bitfinex and Tether did not respond promptly to follow up questions, and when they did subsequently respond, told the OAG that they had already closed a “line of credit” transaction for up to $900 million and that $750 million had already been transferred from Tether to Bitfinex, including November 2018 transfers of $625 million. Id. at 5-6.

The OAG asserts that Bitfinex was using Tether reserves to make up for $851 million that Bitfinex had placed with an overseas entity called Crypto Capital Corp., and which it was unable to recover. Id. at 4-5.

The Injunction

Shortly after it learned of the line of credit transaction, the OAG invoked its powers under the Martin Act to obtain an ex parte injunction. When challenged, however, that injunction did not withstand scrutiny and the court’s modifications recognize important limits on the OAG’s power under the Martin Act.

The Martin Act grants the OAG broad authority to investigate fraudulent practices related to securities or commodities. N.Y. Gen. Bus. Law §352. Once it has determined to bring an action, Section 354 authorizes the OAG to obtain an injunction ordering the production of documents before a complaint is filed. The OAG invoked that power to obtain an ex parte order requiring Bitfinex and Tether to produce documents and restrained them from violating the Martin Act, including by engaging in certain broad categories of transactions.

Bitfinex and Tether (together respondents) moved to vacate or modify the injunction on several grounds, including that the OAG failed to demonstrate that tethers were either a security or a commodity within the scope of the Martin Act, and that the OAG had failed to demonstrate irreparable harm. Dkt. No. 52. They reserved personal jurisdiction defenses.

On May 6, 2019, the court announced a tentative opinion that the original injunction was too vague as to what sorts of financial transactions were prohibited and needed a time limitation, but that a modified injunction and order to produce documents were appropriate. The court invited the parties to propose limiting language to address those concerns.

The OAG proposed minor changes to allow respondents to “fulfill bona fide redemption requests by holders of tethers that are not affiliated with respondents” and to place the reserves in “interest-bearing or other cash or cash-equivalent accounts.” The OAG also proposed that respondents have the burden to move to lift the injunction after 90 days by demonstrating substantial compliance with the document production. Dkt. No. 74.

Respondents proposed more substantial modifications. They proposed an injunction against transactions “that would result in Bitfinex or other affiliated parties having claims on the U.S. dollar reserves being held by Tether,” but with a qualifier that it “shall not preclude other activities in the ordinary course of business.” Similarly, they proposed that the injunction against distributions to associated persons be subject to a proviso that it “shall not preclude payments in the ordinary course of business … .” Respondents also proposed that the injunction expire in 45 days, placing the burden on the OAG to seek an extension. Dkt. No. 72.

The court largely agreed with respondents, recognizing the need to “strike a proper balance between protecting the public from potential violations of the Martin Act and protecting respondents against undue restrictions on their legitimate business activities.” It modified the injunction to preclude “transactions outside the ordinary course of Tether’s business” and distributions to associated persons subject to a proviso that it “shall not preclude payments in the ordinary course of business … .” The injunction expires after 90 days, subject to the AG justifying an extension.

Respondents’ Motion to Dismiss

Shortly after the court modified the injunction, and just before a deadline to produce documents, respondents moved to dismiss the proceeding in its entirety and to stay all document production pending their motion to dismiss. They advance three arguments:

(1) The OAG lacks personal jurisdiction because Bitfinex and Tether do not do business in New York and do not allow New Yorkers on their platforms;

(2) The challenged conduct does not fall within the Martin Act because Tethers are neither securities nor commodities; and

(3) Section 354 of the Martin Act does not apply extraterritorially and therefore cannot be used to obtain the documents maintained outside the United States.

The court responded promptly, staying all document production except as it relates to personal jurisdiction, and set a briefing schedule culminating in a July 29 hearing. Dkt. No. 80.

It is not clear that the court will take on the scope of the Martin Act at this stage. In its opinion modifying the injunction, the court noted that while respondents claim “tether” does not constitute a “security,” the OAG disagrees “and, more importantly for present purposes, advises the court that she requires additional facts to make a determination.” On that basis the court found that it “premature and inconsistent with section 354 for the court to interpose itself to truncate petitioner’s investigation.” Dkt. No. 76.

However, if the OAG cannot establish a jurisdictional link between New York and the Bitfinex trading platform, the proceeding may hinge on whether New York residents holding tether are sufficient to confer jurisdiction. As a “stablecoin” it carries no expectation of profit by design (because it will never be worth more than $1), casting doubt on whether it is a security, and it is also not clear that contractual right to redeem a U.S. dollar fits within conventional definitions of a commodity. It is unclear what additional facts the OAG may argue are required to make that determination.

The next steps in the proceeding against Bitfinex and Tether raise fundamental questions of how far the OAG can go to investigate foreign companies that take steps to avoid New York, and what burdens it can place on them, before the OAG must establish a basis for personal and subject matter jurisdiction. The crypto industry should be watching closely.

Reprinted with permission from the June 14, 2019 edition of the New York Law Journal © 2019 ALM Media Properties, LLC. All rights reserved. 
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