The FBI Has Some Questions for Polymarket
Polymarket founder Shayne Coplan may not be interested in politics, but politics is interested in him.
I started Brogan Law to provide top quality legal services to individuals and entities with legal questions related to cryptocurrency. Cryptocurrency law is still new, and our clients recognize the value of a nimble and energetic law firm that shares their startup mentality. To help my clients maintain a strong strategic posture, this newsletter discusses topics in law that are relevant to the cryptocurrency industry. While this letter touches on legal issues, nothing here is legal advice. For any inquiries email aaron@broganlaw.xyz.
There’s never a dull moment in cryptocurrency, and this week was no exception. In the aftermath of Donald Trump’s election, Bitcoin has seen a major increase in spot price, riding from $69,000 on November 4th to its current price around $89,500 (as of 6:17pm EST Sunday Nov 17). Other tokens like SOL and XRP have experienced even more dramatic price increases. Amidst this euphoria, real questions about the legal treatment of cryptocurrency and related products continue to evolve. Today, we’ll explore a few of these.
The FBI did a Raid
Imagine you are Shayne Coplan. You develop an avid interest in the theoretical prediction markets as a college student at NYU. You read everything Robin Hanson has written and ultimately leave school to build a prediction market on crypto rails. You launch that market, called “Polymarket”, in 2020 and gain some traction, but in 2022, the CFTC comes after you, and you enter a settlement agreement through which you agree to pay a modest penalty and the CFTC orders you to “cease and desist from violating the [Commodities Exchange Act (CEA)].”1
This is unfortunate, but maybe the United States just isn’t ready for these products. You move your company to Panama and geofence the United States to comply with the agreement. Some time passes and as the 2024 United States presidential election approaches, you begin to experience massive global popularity as a forum to bet on the outcome. Your platform synthesizes a high volume of bets, experiencing an 7,043% increase in trading volume in 10 months. Your volume is more than ten times that of your nearest competitor, Kalshi.
The market price this generates suggests Donald Trump is a strong (though not overwhelming) favorite to win the election, in contrast to the predictions of traditional poll aggregators like Nate Silver, who project the race as a toss-up.
Many on the left confuse message with intent and accuse you of manipulating the markets. A French trader named “Théo” bets size on Trump while some suspect him to be an alter-ego of Elon Musk and publications question your reliability. But, come November 5th, Trump wins by a substantial margin and this suggests that your product may have had greater fidelity to ground truth than polls alone. This is seen by many as a vindication of your product.
More than this, Trump has won, and (perhaps misguidedly) you are perceived as being on his side. The regulators he will put in place are likely to view you favorably. Commentators suggest this posture will likely pay “unpredictable dividends.” You announce your plans to return to the United States market. Things are going well.
You are 26 years old, fabulously wealthy, and newly famous. So, if you are Shayne Coplan, you are probably sleeping good on November 13 when the FBI busts in the door2 of your Manhattan home and seizes your electronics.
While it is not clear yet exactly why the FBI raided Mr. Coplan’s home, the New York Times reported that it is as part of a criminal investigation of whether Polymarket operates as “unlicensed commodities exchange, allowing users in the United States to place bets in violation of a settlement with the U.S. government.” It is somewhat atypical for the CFTC to work with the FBI, but it seems that the charges under investigation may stem from 7 U.S. Code § 13 which prescribes felony penalties for the operation of unlicensed commodities exchanges, stating:
It shall be a felony punishable by a fine of not more than $1,000,000 or imprisonment for not more than 10 years, or both, together with the costs of prosecution, for:...
(5)Any person willfully to violate any other provision of this chapter, or any rule or regulation thereunder, the violation of which is made unlawful or the observance of which is required under the terms of this chapter
Elsewhere, the CEA provides in 7 USC § 6 :
“it shall be unlawful for any person to offer to enter into, to enter into, to execute, to confirm the execution of, or to conduct any office or business anywhere in the United States, its territories or possessions, for the purpose of soliciting or accepting any order for, or otherwise dealing in, any transaction in, or in connection with, a contract for the purchase or sale of a commodity for future delivery”
The original Polymarket Order also specified other provisions of the CEA 7 USC § 6c(b) and 7 USC § 7b3(a)(1), which further prohibit unregistered offerance of certain option products.
Given the wording of the statute, it seems plausible that the CFTC (in concert, in this case, with the U.S. Attorney’s Office for the Southern District of New York) could support colorable charges for an unregistered prediction market like Polymarket on this basis alone. That said, the timing of this action is strange, to say the least. With the raid coming immediately after an election in which the President’s party lost, some, including Coplan himself, have argued that it is political retribution for Polymarket’s perceived role in Trump’s victory.
But this political angle cuts both ways. If it is true that the raid was a political attack by the Biden administration, then it can be just as easily reversed by the incoming Trump administration if they choose to drop the investigation. Indeed, Trump has already selected his nominee for the next U.S. Attorney in SDNY, well known attorney and former SEC Chair Jay Clayton.
It seems more likely to me, though, that the raid is not top down political retribution from the executive, but rather the culmination of frustration at the CFTC itself at the extreme publicity Polymarket received during the election season. If this is the case, it is possible that they had planned this action for some time, and waited until after the election for the purpose of avoiding claims of election interference. We may never know for sure.
It is still odd, though. After all, Polymarket has operated for years using its geofencing strategy. There have long been reports of US users accessing the platform anyway using a Virtual Private Network (VPN), and if the CFTC believed that this strategy was a violation of the ‘22 Order, they had ample opportunity to say so in the intervening years. That Order itself is silent on whether this strategy is sufficient to comply.
I spoke to CoinDesk about this problem on Thursday, and the basic issue is this: the CEA makes it blanket illegal to offer these products unregistered to US Persons. Even if you take steps like geofencing to prevent people in the United States from accessing your unregistered products, to the extent they are able to circumvent your restriction, you may still be breaking the law. Even if there wasn’t anything you could have done about it!
This is unintuitive to many founders with engineering or other non-legal backgrounds. To them, it makes more sense that the law would be fair. It should be the case that having taken all the necessary steps to prevent US Persons from using your platform, when some US Persons circumvent them and access it anyway, you aren’t legally culpable. I understand this perspective, of course, but it is wrong.
Federal administrative law, unfortunately, was not written to be fair. It was written to give members of the federal government control. Particularly since Dodd-Frank in 2010, regulators in the United States have enjoyed broad authority to enforce financial law outside of traditional geographic or market boundaries. This allows them to craft de facto rules and practices through enforcement. They permit some entities to operate by conforming to these unwritten standards, but always maintain the legal authority to arbitrarily reverse course and shut them down when they feel it is appropriate to do so. This is a very powerful posture for the government, and that is the point.
As far as I am aware, no court has ever addressed the question of whether a foreign entity making good faith efforts to avoid the US market could still be subject to the CEA, so perhaps there will be a legal fight ahead for Mr. Coplan. On the other hand, if Mr. Trump does perceive Polymarket as an ally for correctly predicting his win, then maybe he will save the young founder by directing Mr. Clayton to drop the investigation or through his pardon power. At this point, nobody knows for sure.
Still, it is hard not to reflect on the position Polymarket found itself in this autumn and think they were reckless in absorbing this risk. It is unclear if the CFTC told them that operating with a geofencing program was sufficient to comply with the ‘22 Order, but surely they were aware that US Persons were able to, and in some cases were in fact, circumventing the restrictions that they had put in place. They were also particularly vulnurable because for all the efforts to incorporate internationally, they are still phyically located in the United States.
As Polymarket became increasingly visible over the months around the election, and processed billions of dollars of transactions, it became inevitable that regulators everywhere would at least consider the legal merits of their product. Particularly in the United States where the CFTC is still fighting a high profile legal battle with registered market participant Kalshi over the very contracts that were delivering Polymarket so much attention. Doing American TV hits post-election could easily be interpreted as thumbing your nose at the regulator.
On some level, this may have been unavoidable. When you get big fast you often won’t have time to implement controls and manage risks. You’ll be spending all your time just keeping your product running. If I was Shayne Coplan, though, I might have considered hanging out in Dubai for a while instead of going on CNBC. Now he’s in the cyclone and just has to hope he gets out without jail time.
This matter is far from settled, and I have often argued that the point of new cryptocurrency ventures is to displace overbearing or archaic regulation, but it should still be a lesson to young projects. It is essential to develop products with arguments or paths to legality. While it is true that small ventures are often able to evade enforcement simply because agencies do not have the time or resources to identify every violation, we all aspire to grow and become eminent in our domains. At that later point where you have found the success you are seeking, you may no longer have available levers to bring your product into compliance, and instead be stuck in the unenviable position of being very visible with only sketchy legal underpinnings to support you. When that happens, you might wake up to a knock on the door and find the FBI there, and that's no fun.
Some States Sued the SEC
I am agnostic to what that path to legitimacy is, though. And one promising approach for the cryptocurrency industry is to fight to change the law itself (or, failing that, the enforcement practices of federal agencies). Over the past few months, I have written a few times about the ongoing legal battle led by Crypto.com to challenge SEC enforcement practices. Basically, Crypto.com received a Wells notice and instead of sitting around waiting for the knock they took the fight to the SEC in E.D.Tex. Their broad argument is that the SEC has promulgated a de facto “rule” that cryptocurrencies are securities subject to SEC regulation, and that that rule is illegal. While that case is ongoing, several others have joined the fight.
Last Thursday, eighteen state attorneys general and the DeFi Education Fund (DEF) together sued the SEC and the five commissioners in the United States District Court for the Eastern District of Kentucky, arguing that:
The SEC’s policy of treating secondary transactions in common digital assets as uniformly “investment contracts,” and of treating platforms that facilitate such transactions as securities exchanges, broker-dealers, and clearing agencies subject to the registration requirements of the Securities and Exchange Acts, exceeds the scope of the agency’s statutory authority and unlawfully wrests primary regulatory authority away from States. And it has the practical effects of impermissibly preempting state laws regulating money transmitters, interfering with state unclaimed property regimes, and imposing broader economic harms on States. It also has harmed and will continue to harm the entire digital asset economy, from platforms, to users, to asset creators and issuers, and to organizations like DEF.
The plaintiffs seek a number of declaratory judgments finding that certain digital asset transfers are not covered by applicable law, that the SEC has violated the Administrative Procedures Act (APA), and enjoining the SEC from bringing further action.
If you read the Crypto.com complaint, or coverage of that action, you will recognize that many of these arguments are familiar to that complaint. Some are different, like a major question point that cites our former guest Eric Wessan’s arguments in JLPP (Mr. Wessan is a signatory to the states’ complaint in his role as Solicitor General of Iowa). In general, though, one would expect that any court that agrees with Crypto.com’s arguments would also be persuaded by the states’, and vice versa.
That is not to say that this complaint adds nothing, though, quite the opposite. While Crypto.com’s ability to advance their declaratory judgment action depends on a somewhat novel and speculative standing argument (that a Wells notice is a sufficiently final agency action3), the states’ complaint does not. Instead, the states’ argue that they have standing because the applicability of the Exchange Act would crowd out many state laws, such as state money transmitter regimes, that are explicitly preempted, and that “[w]hen a federal regulation purports to preempt state law, states have a sovereign interest to sue the United States.” (citations omitted).
While this argument may or may not prevail, its outcome is likely not strongly correlated with the outcome of the Crypto.com standing argument, and so it is a strong compliment for the industry. We want the substantive arguments the complaints pose to be heard by federal courts, and perhaps, ultimately, the Supreme Court, and so having multiple bites at the apple is a very good thing.
One notable limitation of this complaint, however, is that it only purports to cover tokens that “[do] not transfer any stake in any enterprise that the seller or anyone else has an obligation to manage for the asset owner’s benefit and share resulting profits.” This limitation has gained certain vogue among crypto practitioners this year, perhaps as a necessary concession to the Howey test, but I personally do not think we should give up so easily here.
In the past, practitioners have advanced arguments like “consumptive use” that would preclude the applicability of securities law, relying on a 2019 “Framework for Digital Assets” issued by the SEC. While this particular argument has failed in certain cases, such as the 2020 SEC v. Telegram ruling in SDNY, it has not, to my knowledge, ever failed in the 5th Circuit or Supreme Court. It may be too early to concede it, since, in my view, the ability of tokens to function as quasi-equity stakes in new enterprises is core to the value proposition of cryptocurrency writ large as a novel less-regulated capital market.
This is not a criticism of any of the attorneys advancing arguments in these cases—it's often better to advance the limited arguments that you know you can win rather than a broader, more speculative one. It is a call, though, to professionals to reconsider whether we should so quickly admit that some tokens are probably securities.
While we may ultimately need new legislation to inculcate the industries affirmative legality, there are models proposed elsewhere, like Europe’s Markets in Crypto-Assets Regulation (MiCA), which do not rely exclusively on the fractional ownership and expectation of profit characteristics that American courts currently consider in applying securities law here. We should adopt this best practice as possible.
There is much more to discuss as the regulatory environment is certain to change rapidly over the next year, but for that, you’ll have to wait till next week! As always, Brogan Law is following changes in the crypto legal world daily, and is always ready to assist you, your portfolio companies, or anyone else when needed. We’ll leave you with this interesting discussion between Marc Andreessen (a Trump donor) and Ben Horowitz (a Harris donor) on the aftermath of the 2024 election and its impact on regulation moving forward.
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I’ve always found this feature of enforcement orders odd. The CEA is the law, so Polymarket was already prohibited from offering markets that violate it. I’m not sure about the strategic thinking, then, for including it again. But I digress.
While a picture of a hole in Mr. Coplan’s door has been circulating on social media, it appears to be traceable back to 2020. There is no evidence that the FBI actually broke down his door, and it is much more likely they knocked. I left this language in because it sounds more dramatic, for effect.