California DOJ Takes Aim at Crypto Trading Platforms: What You Need to Know
On September 4, 2024, the California Attorney General’s office reached a $3.9 million settlement (the “Settlement”) with a cryptocurrency trading platform. This marks the first public enforcement action by the California Department of Justice (“CA DOJ”) against a cryptocurrency company, as well as the first application of the state's commodity laws to cryptocurrency. While the CA DOJ’s focus on consumer protection is commendable, the Settlement exhibits features of “regulation by enforcement.” Its lack of specific legal guidance leaves cryptocurrency companies uncertain about how California laws apply to their operations.
Background: How the Case Developed
According to the CA DOJ’s press release, the enforcement action was initiated following consumer complaints alleging “questionable behavior in the cryptocurrency industry.” The CA DOJ reportedly launched an investigation into the platform’s operations from January 2018 to April 2022, focusing on various aspects of the platform’s business practices, including its handling of customer assets, settlements of cryptocurrency transactions, and representations regarding order routing and pricing. According to the press release, the CA DOJ’s settlement focused on the following conduct:
(1) The ability or inability of the platform’s customers to withdraw their cryptocurrency assets to their own external wallets;
(2) Delayed settlement of certain cryptocurrency transactions during periods of network instability caused by 51% attacks on certain blockchains;
(3) The routing and order handling of certain cryptocurrency orders; and
(4) Representations, disclosures, or potential omissions to existing and potential customers of the platform regarding the above issues.
Without admitting or denying the CA DOJ’s alleged violations, the trading platform agreed to:
(1) Continue allowing customers to withdraw their cryptocurrency to external wallets in accordance with Cal. Corp. Code Section 29520;
(2) Take reasonable steps to ensure written representations to customers about its trading and order handling practices are materially reflect actual practices; and
(3) Maintain certain language in customer agreements regarding cryptocurrency custody and include specific language to address potential transaction settlement delays.
Is a cryptocurrency a “commodity” under California laws?
The Settlement lacks detail on the specific laws at issue except to cite California Corporations Code Sections 29520 and 29505 with respect to customers’ inability to withdraw their cryptocurrency to external wallets (i.e., a lack of an ability to receive “actual physical delivery” of their cryptocurrency). The Settlement also lacks details on the potential alleged violation of California’s commodities laws, but presumably is based on the following theories:
Section 29520 generally prohibits buying or selling "commodities" under a "commodity contract" absent an exemption Sections 29530 to 29532. None of these exemptions likely apply to the transactions at issue here. Therefore, the cryptocurrency transactions on the platform could violate Section 29520 if cryptocurrency is a "commodity" and the transactions are "commodity contracts."
Section 29505 generally defines a "commodity contract" as an agreement to buy or sell a "commodity" primarily for speculation or investment purposes and not for consumption. However, the definition excludes any contract or agreement that requires and gives the purchaser "actual physical delivery" of the amount of each commodity bought under the agreement within 28 days of payment. So, if cryptocurrency is a "commodity" and the purchaser gets "actual physical delivery" within 28 days of payment, then the transaction is not a "commodity contract" and is not subject to the prohibition of Section 29520. Hence, the Settlement requires customers to be able to withdraw their cryptocurrency to their external wallets. The DOJ’s concern about delayed transaction settlements also may be implicated here, but that is less clear from the Settlement.
A core element about which the Settlement is also silent is whether cryptocurrency is a “commodity” under California law as a general proposition (or if not, which specific cryptocurrencies available on the exchange were considered by the CA DOJ to be commodities). The definition of “commodity” under Cal. Corp. Code Section 25904 does not explicitly mention cryptocurrency, and the CA DOJ has not previously provided any guidance on whether this section includes cryptocurrencies. Likewise, the California Department of Financial Protection & Innovation (“DFPI”) has provided limited guidance on the status of when a cryptocurrency might be a commodity under California law.[1] However, Section 25904 broadly defines commodity to include “goods” which has been cited at the federal level as being broad enough to bring cryptocurrencies with the definition of “commodity” under the Commodity Exchange Act (“CEA”).[2] Presumably, the CA DOJ has taken the same view here, but observers can only speculate.
Observations
More regulation by enforcement?
The Settlement carries hallmarks of the controversial “regulation by enforcement” approach to cryptocurrency that has defined certain federal regulatory efforts in recent years. As that term is used here, “regulation by enforcement” is generally understood to mean the creation of digital asset regulation not through formal legislation or rulemaking, but through enforcement action (e.g., investigations and/or civil litigation) against often unsuspecting market participants. As noted above, the CA DOJ previously had not issued public guidance regarding whether cryptocurrency could be subject to the State’s commodities laws. The California Attorney General’s press release also highlights that this Settlement is the first public action by the CA DOJ against a cryptocurrency company. Prior to the settlement, the application of California’s commodities laws to cryptocurrency was largely speculative. This absence of prior guidance raises the concern that the CA DOJ may be relying on enforcement actions rather than rulemaking to shape cryptocurrency regulation.
The move and timing is also peculiar in light the passage of California’s Digital Financial Assets Law (“DFAL”) in October 2023 which is set to take effect July 1, 2025. While the implementation of the DFAL is yet to be determined through rulemaking by the DFPI, the DFAL generally provides comprehensive legislation, often referred to as California’s “BitLicense,” to establish detailed licensing and compliance requirements for cryptocurrency platforms. Importantly, the DFAL provides a definition of “digital financial asset” that would likely capture most, if not all, of the cryptocurrencies at issue in the Settlement. The Settlement raises the question of whether the CA DOJ will continue to pursue potential violations of the State’s commodities laws after the DFAL is effective and implemented and sets up potential regulatory overlap, conflicts and redundancies between the DFPI and the CA DOJ.
Implications beyond California?
While some of the issues above are unique to California, it is notable that the California Commodities Laws are based the NASAA Model State Commodity Code (“Model Code”) which has been adopted in some form by nearly half the States. As such, the Settlement creates regulatory risk that these other Model Code states could follow California’s lead and test the boundaries of their enforcement authority over cryptocurrencies traded in spot markets via state commodities laws.
Takeaways for Cryptocurrency Platforms
Review Customer Agreements: Cryptocurrency platforms should ensure their customer agreements align with their actual practices, particularly regarding order handling, cryptocurrency custody and transaction settlements. The Settlement highlights the potential for additional scrutiny of the customer agreements of cryptocurrency platforms operating in California, and potentially other Model Code states. Cryptocurrency platforms should perform a review of their customer agreements in light of the Settlement and consider whether incorporating the specific language related to delayed settlements required by the CA DOJ in this case would also be applicable to their platforms.
Customer Access to Their Cryptocurrency: Cryptocurrency platforms operating in California and other Model Code states should also review customers’ ability to withdraw cryptocurrency to external wallets from the platform and transaction settlement for compliance with state commodities laws.
Reminder to Prepare for the DFAL: With the DFAL taking effect in July 2025, cryptocurrency platforms desiring to operate or continue operating in California should be seriously considering applicability of the new licensing requirement.
PierFerd’s FinTech and Blockchain team continues to monitor regulatory activity affecting our client and the digital asset and blockchain industry. Please reach out for more information or assistance.
Gavin Meyers gavin.meyers@pierferd.com
William Kraus william.kraus@pierferd.com
This publication and/or any linked publications herein do not constitute legal, accounting, or other professional advice or opinions on specific facts or matters and, accordingly, the author(s) and PierFerd assume no liability whatsoever in connection with its use. Pursuant to applicable rules of professional conduct, this publication may constitute Attorney Advertising. © 2024 Pierson Ferdinand LLP.
[1] See, e.g., Anonymous, DFPI Interpretive Letter, OP-8141 (Oct. 20, 2021) (advising that certain asset backed tokens “could” be considered a commodity under California law); Bitnatx, DFPI Desist and Refrain Order (Oct. 6, 2020) (stating that Bitcoin is a commodity).
[2] CFTC v. McDonnell, 287 F. Supp. 3d 213, 228 (E.D.N.Y. 2018) (“[Virtual currencies] fall well-within the common definition of ‘commodity’ as well as the CEA's definition of ‘commodities’ as ‘all other goods and articles ... in which contracts for future delivery are presently or in the future dealt in.’ ”)
