Whistleblowers Key to Combating Cryptocurrency Fraud
This article originally appeared in JD Supra.
In September 2021, the market capitalization for digital assets, such as cryptocurrencies and NFTs, was valued at $2.14 trillion. The cryptocurrency market has attracted a variety of fraudulent activities in which the perpetrators seek to capitalize on unsuspecting investors. Fortunately, the U.S. Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) have stepped in to penalize these newest forms of fraud. As with most enforcement agencies, information is key to enforcing compliance. Thus, these federal agencies will award whistleblowers who provide original information that meets specific criteria. Whistleblowers are offered the option for complete anonymity when providing such information.
The Dodd-Frank Act authorized the SEC and CFTC to provide monetary awards to eligible individuals who come forward with high-quality original information that leads to an enforcement action in which over $1,000,000 in sanctions is ordered. The range for awards is between 10% and 30% of the monies collected.
The Internal Revenue Service’s (IRS) definition of virtual currencies categorizes cryptocurrency as a commodity under the Commodity Exchange Act (CEA). When a virtual currency is used in a derivatives contract or fraud or manipulation involving a virtual currency traded in interstate commerce, CFTC enforcement of the CEA comes into play.
Recently, the CFTC charged Jon Thompson with knowingly or recklessly making false representations to customers to finance the purchase of over $7 million of Bitcoin. Thompson induced two customers to send him money by falsely representing that he or his company possessed $7 million worth of Bitcoin. The CFTC alleges Thompson lied about the status of customers’ money, the location of the Bitcoin, and why he did not complete the transaction. The customers never received the Bitcoin, and Thompson did not safeguard their funds as promised. While the CFTC proceeds with litigation against Thompson, it seeks restitution, permanent trading and registration bans, and civil monetary penalties for violating the CEA and CFTC regulations, as charged.
Cryptocurrency frauds penalized by the CFTC are not only limited to what occurred in the Jon Thompson matter. Anyone can report original information to the CFTC if they witness any of the following:
- Price manipulation (like pump-and-dump schemes) involving virtual currencies and other virtual assets.
- Fraudulently soliciting investments in virtual currencies.
- Pre-arranged or wash trading of virtual currencies, or swaps or futures contracts based on virtual currencies.
- Virtual currency futures or options contracts or swaps traded on an unregistered domestic platform or facility.
- Certain schemes involving virtual currencies marketed to retail customers by unregistered persons, such as off-exchange leveraged, margined, or financed commodity transactions with persons, even without direct evidence of fraud or manipulation.
- Supervision failures or fraudulent conduct (e.g., creating or reporting fictitious trading) by virtual currency exchanges.
When a digital asset is considered a security, the SEC may regulate all market participants who use that asset in transactions. This regulation includes dealers and brokers on the exchanges on which it is traded in the secondary market and companies or funds that invest in it for the benefit of their shareholders. However, not all digital assets are securities. For example, SEC officials have indicated that Bitcoin does not appear to be a security. Therefore, it is not subject to the SEC’s jurisdiction.
In September, the SEC charged Bitconnect, an online cryptocurrency lending platform, with violating the antifraud and registration provisions of the federal securities laws. The SEC alleges the defendants facilitated a fraudulent and unregistered offering and sale of securities in the form of investments in a “Lending Program.” Additionally, the SEC alleges that the defendants induced customers by falsely representing they would use a “volatility software trading bot” with the investor’s funds to create substantial returns. According to the SEC, the defendants instead transferred all the deposits into digital wallets owned by them. The SEC alleges that the defendants stole billions of dollars from investors using this type of scheme.
The SEC is primarily concerned with cryptocurrency securities fraud and Ponzi schemes. Anyone can report original information to the SEC if they witness any of the following characteristics of securities fraud or Ponzi scheme:
- High investment returns with little or no risk. “Guaranteed” investment returns or promises of high returns for little risk should be viewed skeptically.
- Overly consistent returns. Be suspect of an investment that generates consistent returns regardless of overall market conditions.
- Pressure to buy right now. Fraudsters may try to create a false sense of urgency to get in on the investment.
- Unregistered investments. Ponzi schemes typically involve investments that have not been registered with the SEC or with state securities regulators.
- Unlicensed sellers. Federal and state securities laws require certain investment professionals and their firms to be licensed or registered.
- Secretive and/or complex strategies and fee structures. It is a good rule of thumb to avoid investments you don’t understand or for which you can’t get complete information.
- No minimum investor qualifications. Most legitimate private investment opportunities require you to be an accredited investor.
- Issues with paperwork. Be skeptical of excuses regarding why you can’t review information about the investment in writing.
- Difficulty receiving payments. Be suspicious if you don’t receive a payment or have difficulty cashing out your investment.
- The investment comes through someone with a shared affinity. Fraudsters often exploit the trust from being members of a group that shares an affinity, such as a national, ethnic, or religious affiliation. Sometimes, respected leaders or prominent members may be enlisted, knowingly or unknowingly, to spread the word about the “investment.”
Both the SEC and CFTC Whistleblower Programs have been highly successful. Since issuing its first award in 2012, the SEC has awarded over $1.1 billion to over 200 whistleblowers. In October, the CFTC issued the largest Dodd-Frank whistleblower award in history: a $200 million award.
Individuals do not need to be an insider to qualify for a whistleblower award. Anyone with original information, such as victims of fraud and other market participants who observe misconduct, may be eligible for an award. If someone witnesses something suspicious, whether it falls under the jurisdiction of the SEC or CFTC, they can report it. It is highly recommended that people with information consult with a whistleblower attorney before making such a report. The process is also complex. If not done correctly, they may not qualify for the award. A whistleblower attorney will be better equipped to ensure anonymity and a whistleblower reward when reporting to both agencies.
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