Recent Actions by US Regulators Expose Local Virtual Currency Businesses to Pandora’s Box of Legal Risks

More than 60 percent of businesses operating in the so-called virtual currency space are reportedly based in Hong Kong and Mainland China. These businesses may be surprised to learn that they can be exposed to possible government enforcement actions and private litigation in the United States based on conduct taking place in their local jurisdiction. 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 virtual Pandora’s box of possible legal consequences for virtual currency businesses operating in the Greater China region.

HK-Based Virtual Currency Businesses Are Exposed to Government Enforcement Actions in the United States

The US government has been flexing its muscles to police virtual currency markets around the world. They have recently brought a number of actions against businesses in Hong Kong 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 United States that has an effect within the United States. While the US government’s legal reach may not be valid and is open to dispute, that may be of little comfort to companies and individuals charged with illegal activity in the United States.

Three US enforcement bodies are leading the competition to become the top regulator in the virtual currency space: the US Securities and Exchange Commission, the US Commodity Futures Trading Commission, and the US Internal Revenue Service.

US 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.

The classification of virtual currencies as “securities” creates important legal consequences for virtual currency businesses around the world – including potentially virtual currency issuers, currency “miners”, investors, traders, exchanges, investment advisers and brokers. The categorisation 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 or market manipulation in virtual currencies or securities fraud.

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 canceling 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. However, 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.

US Commodity Futures Trading Commission

The US Commodity Future Trading Commission (“CFTC”) has also 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 first registering with the CFTC. The CFTC adopted a view that virtual currencies constitute “commodities” and, therefore, Bitfinex was required to register. Bitfinex cooperated 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.

US 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. Hong Kong and Mainland China-based businesses may well face similar requests for records related to US taxpayers.

Virtual Currency Businesses Are Exposed to Private Litigation in the United States

Hong Kong and Mainland China-based companies that deal with US counterparties can also be sued in the United States 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 United States have broad discovery powers that can be weaponised 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.

Virtual Currency Businesses cannot Rely on Technological Anonymity to Protect against US Government Actions or Private Litigation

Clients cannot assume they are protected from US government or private actions by the technological anonymity afforded by blockchain technology. Governments and private parties have ways to break the anonymity surrounding virtual currency trades that impact virtual currency exchanges, money transmitters, and associated individuals.

For example, in the recent BTC-e exchange matter, mentioned above, the US Department of Justice used “blockchain analysis” to identify and locate a Russian national allegedly associated with a massive theft of Bitcoin. The Russian defendant was accused of operating a Bitcoin exchange as an international money laundering vehicle and is currently under arrest in Greece pending an extradition request to the United States.

Private parties have similar capabilities. A Bitcoin security research group recently demonstrated how to reverse engineer blockchain transactions to identify and tie individuals to virtual currency trades using (i) blockchain analysis (similar to that used by the US government) to identify accounts associated with trades and (ii) public records to link and locate individuals associated with those accounts.

How Hong Kong Solicitors Should Respond to US Government Inquiries or Private Lawsuits

Hong Kong solicitors and their clients confronting potential enforcement actions or disputes in the US should consider the following when formulating a defense 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 categorisation 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. Lawyers should develop 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. In order to properly advise their clients, lawyers for virtual currency businesses need to familiarise themselves with other 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 defenses may be available for non-US businesses based in the Greater China region to challenge assertions of personal jurisdiction over them. Hong Kong solicitors who represent virtual currency businesses should also analyse 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 be subject to legal defenses and objections under US procedure, such as the US attorney-client privilege, or other legal privileges including those recognised under Hong Kong law. Before producing documents, information or testimony to the US government or US civil litigants, lawyers for virtual currency operators should carefully assess what a request requires and what legal defenses or privileges may apply under local or US law.

Hong Kong and Mainland China-based virtual currency companies are exposed to overlapping legal risks in their home jurisdictions and in the United States, 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 licenses, and special remedies such as periodic audits or monitorships or supervisory arrangements. Their attorneys must closely monitor the rapidly changing legal landscape in this space, both in the US and globally, so that, should a legal issue arise, they can properly advise their clients regarding potential options to mount an aggressive defense. 

We would like to acknowledge the contributions of Nan Wang, Associate, Kobre & Kim LLP, in preparing this article.


Kobre & Kim LLP, Principal

Benjamin Sauter, a US-based lawyer at Kobre & Kim LLP, routinely represents companies in high-stakes litigation involving commodities, futures, swaps, and other securities and derivatives. His representations often involve clients confronting regulatory and criminal enforcement proceedings. He is part of the Digital Currency & Ledger Defense Coalition, a group of over 50 lawyers dedicated to protecting US blockchain innovators.

Partner, Kobre & Kim 

John Han is admitted as a Solicitor Advocate in Hong Kong, in the United States, and in the Dubai International Financial Centre Courts. He is an accomplished litigator and advocate who helps clients achieve business objectives in matters involving Greater China, the U.S., and English common law jurisdictions including the British Virgin Islands. Clients rely on his deep regional business knowledge and bilingual language capabilities.

Mr. Han has acted as lead counsel in a wide range of cross-border disputes involving monetization and demonetization of US $100M+ judgments and arbitration awards both against and on behalf of governments, state-owned enterprises, and multinational corporations. The matters often involve fraud or misconduct. He regularly leads large-scale cross-border matters to monetize substantial defaulted PRC loan and guarantee portfolios where assets are concealed through complex offshore structures, trusts, and foundations, and where debtors and decision-makers are found in Europe, EMEA, and the U.S