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From Securities Regulation Daily, April 15, 2014

Jurisdiction of CFTC over certain retail commodity transactions affirmed

By Lene Powell, J.D.

In a case of first impression, a three-judge panel of the Eleventh Circuit held that the Dodd-Frank Act had expanded CFTC’s enforcement authority over retail commodity transactions offered “on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.” The transactions at issue involved retail financed transactions in precious metals that never resulted in actual delivery. The panel affirmed the district court’s grant of a preliminary injunction against appellants, the sole officers and members of a commodity brokerage firm, finding that the CFTC had alleged a prima facie case of fraud and the district court had not committed error in concluding there was a reasonable likelihood of future wrongdoing (CFTC v. Hunter Wise Commodities, LLC, April 15, 2014, Dubina, J.).

Off-exchange retail financed transactions in precious metals. In December 2012, the CFTC brought a civil enforcement action against twenty defendants, alleging that they had violated the Commodity Exchange Act (CEA) by conducting off-exchange and fraudulent retail commodity transactions related to precious metals. The defendants included the following companies and individuals: (1) Hunter Wise Commodities, a holding company consisting of four companies, offered market access, financing, and a technology platform for retail precious metals dealers; as well as Hunter Wise officers Harold Martin and Fred Jager; (2) the Lloyds entities, a holding company and two affiliated companies that acted as an intermediary to recruit the dealers to execute retail transactions on behalf of Hunter Wise, as well as two Lloyds officers; and (3) five precious metals dealers and their four managers.

Dealers solicited retail customers by telephone and internet, touting physical metals as safe investments. Customers typically made a down payment of 25 percent and received a loan for the balance of the purported purchase price, with the credit agreement maturing in four years. Dealers required retail customers to maintain 15 percent of their account in equity; if the equity fell below that figure, the customer received a margin call requiring him to deposit additional funds to maintain his trading position. Accounts were subject to a minimum margin requirement; open trading accounts were liquidated if equity dropped below 9 percent. Retail customers could trade based on price movements. The values of customers’ accounts fluctuated with the price of metals and were subject to depletion due to fees, commission, and interest charges. None of the transactions with retail customers took place on a regulated commodity exchange. Although some of the transactions were not financed, the CFTC’s enforcement action applied only to those that were.

Hunter Wise provided the financing made available to retail customers and administered the transactions. The company also assisted dealers in marketing metals and managing the transactions with retail customers, providing training materials, including sales pitch scripts, educational videos, and policy and procedure manuals, for dealers’ employees. Hunter Wise maintained account and trading records for all dealers’ retail customers’ transactions, accessible to both retail customers and dealers. Funds passed from the customer to the dealer to Lloyds and finally to Hunter Wise, with each taking a cut.

No metals inventory. Although Hunter Wise occasionally purchased or sold physical metals, the vast majority of its transactions were margin trades. The district court found that the trading companies did not deliver metal to Hunter Wise such that it could make deliveries to retail customers. The trading companies only delivered metals to Hunter Wise if the firm paid in full—something it never did on margin trades. Therefore, no title to physical metals passed as a result of Hunter Wise’s margin trades with the trading companies. Based on this, the district court found that Hunter Wise had no inventory of metals from which it could deliver to the trading platform’s retail customers.

Preliminary injunction in district court. The district court found that the transactions were subject to the CFTC’s enforcement authority under 7 U.S.C. § 2(c)(2)(D) because they were financed commodity transactions with retail customers. Further, the district court concluded that the CFTC presented a prima facie case of illegality and a likelihood of future violations. Over the objections of some defendants that the CFTC lacked statutory authority for the enforcement action, the district court granted a preliminary injunction and appointed a special monitor to administer the business entities involved. Two defendants, the sole officers and members of Hunter Wise, appealed the injunction.

Jurisdiction over retail commodity transactions. In reviewing the district court’s grant of preliminary injunction for abuse of discretion, the appellate panel reviewed the underlying findings of fact for clear error and questions of law de novo. The panel noted that the standard for a preliminary injunction under the CEA was lower than the familiar formula of substantial likelihood of success on the merits and likelihood of irreparable injury. Instead, the CEA enables district courts to issue injunctions “upon a proper showing”, consisting of a prima facie case of illegality and a reasonable likelihood of future violations.

The panel characterized defendants’ argument on appeal as a claim that there was no cause of action, for a preliminary injunction or otherwise, under the CEA and therefore that the CFTC had not stated a claim to relief. However, the panel found that the CFTC did have jurisdiction under §2(c)(2)(D) of the CEA, as added by the Dodd-Frank Act. The CFTC has authority over certain retail commodity transactions. The transactions were “retail” because the customers who entered into contracts via Hunter Wise’s system were not eligible contract participants. And because the customers were individuals, they were not eligible commercial entities.

Leveraged or margined basis. The panel found that the transactions were entered into “on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.” Appellants argued that the contracts they offered were not “leveraged” under a definition of that term in 7 U.S.C. § 23, which provided that such a contract is “for the long term (ten years or longer) purchase … or sale” of a leverage commodity by a leverage investor. Because the Hunter Wise contracts matured in just four years, the appellants contended they were not leveraged contracts. However, the panel declined to import the meaning of that section into §2(c)(2)(D), noting that the two sections did not refer to each other and adopting the 10-year interpretation would render §2(c)(2)(D) meaningless. Giving the terms “leveraged” and “margined” their plain and ordinary meaning, the panel found that the Hunter Wise contracts were leveraged, margined, or similarly financed and therefore subject to the Commission’s authority.

The panel found that appellants’ insistence that Hunter Wise was a wholesaler did not save them from the CEA’s reach, as “Hunter Wise controlled the entire scheme with a tight fist,” and it was beyond dispute that “Hunter Wise at least had its fingers—if not its hands—in each stage of the scheme.”

No “actual delivery” of metals. The panel observed that an exception to the CFTC’s authority over retail commodity transactions exists for contracts of sale resulting in actual delivery, or which create an enforceable obligation to deliver between parties with the ability to deliver. Rejecting appellants’ urging to use the definition of “delivery” provided by Article 2 of the Uniform Commercial Code, the panel looked to the ordinary meaning of “actual delivery” and defined it as the act of giving real and immediate possession to the buyer or the buyer’s agent. Using this definition, as well as the CFTC’s informal interpretation, the panel found that no actual delivery could occur because, as the district court found, Hunter Wise had nothing to deliver as it did not own a sufficient inventory of metals to cover its liabilities to the retail customers. Therefore, the “actual delivery” exception did not apply.

Fraud adequately alleged. The panel said the CFTC had offered evidence on each element required to establish liability for fraud: (1) the making of a misrepresentation, misleading statement, or a deceptive omission; (2) scienter; and (3) materiality. Hunter Wise, via the trading platform, had represented to retail customers that the customers were buying and selling physical metals and that dealers were storing metals in depositories on customers’ behalf, when in fact the appellants knew Hunter Wise maintained margined trading positions in metals rather than physical inventory. The misrepresentations were material, as a reasonable investor would consider representations about the nature of the transaction important in deciding whether to make an investment.

Standard for preliminary injunction met. The panel found that the CFTC pleaded and presented ample evidence that the transactions were subject to the CEA and did not take place on an exchange, and alleged a prima facie violation of the fraud provisions of 7 U.S.C. § 6b. Further, the district court’s finding that there was a reasonable likelihood of future wrongdoing was not error. The panel declined to decide whether the CFTC’s allegations that Hunter Wise’s use of scheme or artifice to defraud, in violation of 7 U.S.C. § 9(1), provided an independent basis for affirming the district court’s preliminary injunction and affirmed the district court’s grant of the preliminary injunction.

The case is No. 13-10993.

Attorneys: Anne Stukes for the CFTC. Jay Bruce Grossman (J.B. Grossman, PA) for Harold Edward Martin, Jr. and Hunter Wise Commodities LLC

Companies: Hunter Wise Commodities, LLC.

MainStory: TopStory Enforcement FraudManipulation CommodityFutures DoddFrankAct AlabamaNews FloridaNews GeorgiaNews

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