The Dodd-Frank Act, the CFTC’s Crackdown on Off-Exchange Financed Commodity Transactions, and the Role of the Court-Appointed Fiduciary
by Kenneth Dante Murena*
Investors who have braved the mine fields of purchasing precious metals outside of a registered exchange have for years been exposed, whether they knew it or not, to exorbitant fees and calculated misrepresentations, not to mention market risks, and often find themselves at the end of the day without any actual metals. Recently, however, the U.S. Government has made significant efforts to sweep those fields clean.
The Dodd-Frank Act
On July 16, 2011, Congress empowered the U.S. Commodity Futures Trading Commission (the “CFTC”) to protect investors from the exorbitant fees and substantial trading losses often associated with off-exchange financed commodity transactions. Indeed, that was the effective date of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), which, among other things, (i) extends the CFTC’s jurisdiction as set forth in Sections 4(a) and 4(b) of the Commodity Exchange Act (the “Act”) to reach financed sales of commodities to retail customers (with limited exceptions), pursuant to Section 2(c)(2)(D) of the Act, (ii) requires that these transactions be conducted on a registered board of trade, and (iii) subjects them to the anti-fraud provisions set forth in Section 6(c) of the Act. In particular, the Dodd-Frank Act adds to the Act Section 2(c)(2)(D), entitled “Retail Commodity Transaction”, which applies to “any agreement, contract, or transaction in any commodity that is entered into with, or offered to, a non-eligible contract participant or non-eligible commercial entity on a leveraged, margined, or financed basis.” This Section does not apply where the sale “results in actual delivery within 28 days or such other longer period as the Commission may determine by rule or regulation based upon the typical commercial practice in cash or spot markets for the commodity involved . . .” and other limited circumstances. Accordingly, the Dodd-Frank Act authorizes the CFTC to bring enforcement actions against those that engage in off-exchange financed retail commodity sales and do not meet the applicable delivery requirements.
The Enforcement Action Against Hunter Wise
One such enforcement action is United States Commodity Futures Trading Commission v. Hunter Wise Commodities, LLC, et al., pending in the United States District Court for the Southern District of Florida (the “District Court”), Case No. 12-CV-81311 (the “Hunter Wise Action”), in which the CFTC alleges that the off-exchange financed commodities transactions and other conduct of Hunter Wise Commodities, LLC and several of its affiliated dealers (collectively, “Hunter Wise”) and their respective principals (collectively, the “Individual Defendants”, and together with Hunter Wise, “Defendants”), violated the Act, Section 742 of the Dodd-Frank Act, and certain of the CFTC’s Regulations. The CFTC sought restitution, rescission, civil monetary penalties and equitable relief, including (i) enjoining Hunter Wise’s allegedly unlawful practices, (ii) compelling compliance with the Act, the Dodd-Frank Act, and regulations promulgated thereunder, and (iii) the appointment of a receiver over Hunter Wise.
In the Hunter Wise Action, the CFTC alleges that, since the Dodd-Frank Act became effective on July 16, 2011, Hunter Wise engaged in illegal, off-exchange, financed commodity transactions with retail customers and did not satisfy the applicable delivery requirements. Further, the CFTC alleges that Hunter Wise engaged in extensive fraud and that, between July 16, 2011 and August 31, 2012, Hunter Wise received more than $46,000,000 in retail customer funds in connection with such transactions.
In particular, the CFTC alleges that Hunter Wise made at least three material misrepresentations to customers: (1) Hunter Wise sells and transfers ownership of physical metals to customers; (2) Hunter Wise makes loans to customers to purchase the physical metals; and (3) Hunter Wise arranges for storage and stores customers’ metals in independent depositories. The CFTC alleges that Hunter Wise does not actually take any of these actions but, instead, charges customers commissions on the purchase of metals, charges interest on loans to finance such purchases, and charges storage fees on those metals in connection with paper transactions that only allow customers to speculate on the price direction of metals. The CFTC claims that such conduct violates the Act, the Dodd Frank Act, and certain CFTC Regulations.
Preliminary Injunction and Appointment of a Fiduciary
After holding an evidentiary hearing on the CFTC’s motion for preliminary injunction and to appoint a receiver, the District Court appointed Melanie E. Damian as Special Monitor and Corporate Manager (the “Monitor/Manager”) over Hunter Wise (the “Appointment Order”), and entered an Order granting the CFTC’s Motion for Preliminary Injunction against Hunter Wise (the “Injunction Order”). Certain of the Individual Defendants have appealed these Orders, and such appeal is currently pending before the United States Court of Appeals for the Eleventh Circuit.
The Monitor/Manager’s mandate was “to examin[e] [Hunter Wise’s] finances and options, and make [a] recommendation about the alternatives to maximize the operations and asset value of [Hunter Wise]” for the benefit of creditors, investors (mostly retail customers), and non-complicit member owners of Hunter Wise. Further, the Monitor/Manager was charged with marshaling and securing all assets of Hunter Wise and administering the corporate monitorship estate (the “Monitorship Estate”).
Given the desire to preserve Hunter Wise’s assets, the District Court also assigned to the Monitor/Manager the function of Corporate Manager for the Entity Defendants and charged her with submitting a report detailing the viability of Hunter Wise as a going concern, in light of the preliminary injunction, which prohibited the central business of Hunter Wise – the financed sale of unallocated precious metals.
The Injunction Order expanded and provided further justification for the injunction set forth in the Appointment Order, and added to the Monitor/Manager’s duties and responsibilities, including marshaling and securing the assets of the Individual Defendants. To that end, the Injunction Order required the Individual Defendants to turnover all of their assets to the Monitor/Manager. Further, the Injunction Order required the Individual Defendants to submit a complete accounting of their personal finances as well as of any funds and assets they controlled in connection with Hunter Wise, and all documents pertaining thereto.
Monitor/Manager’s Efforts to Marshal Assets of the Monitorship Estate
Hunter Wise’s operations were based in Irvine, California and Las Vegas, Nevada, and its dealer network spread throughout the United States, including South Florida where all of the named dealer Defendants were located. Immediately following her appointment, the Monitor/Manager and her counsel traveled to the offices of Hunter Wise and the dealer Defendants, took control of and assessed the business operations, interviewed employees and made determinations concerning winding down operations and closing the offices while preserving the value of the assets located therein. The Monitor/Manager interviewed and/or deposed certain of the Individual Defendants and took steps to secure the turnover of their valuable assets purchased with funds traced to retail customers. The Monitor/Manager also communicated with numerous dealers all over the United States to better understand the operations of and dealings between Hunter Wise and its dealers.
In the first few days of the monitorship, the Monitor/Manager also took possession or control of all known assets of Hunter Wise, including the assets that were invested in over-the-counter margin trading accounts. The majority of Hunter Wise’s equity was invested in margin trading accounts with several trading firms. In these trading accounts, Hunter Wise held leveraged trading positions in gold, silver, platinum and palladium. On the next business day following her appointment, to eliminate the market risk to Hunter Wise’s retail customers, the Monitor/Manager, working with her counsel and the CFTC, liquidated the more than $45 million in open tradable precious metals positions of Hunter Wise. Because those tradable positions were highly leveraged, with the financed portion of the transaction generally accounting for at least 75% of the total transaction amount, the liquidation value obtained by the Monitor/Manager was only approximately $5 million. Given that the metals market plummeted only weeks later, the Monitor/Manager’s converting the open positions to cash when she did saved the retail customers, in the aggregate, more than $1 million.
The Monitor/Manager’s review and analysis of accounts held at various trading firms, as well as an inspection of Hunter Wise’s offices in Irvine, California revealed a limited quantity (as compared to the retail customers’ total investments) of precious metals that were actually held by Hunter Wise as “collateral” for retail customers. In particular, the Monitor/Manager discovered that Hunter Wise held physical precious metals at one depository with a total market value just over $1 million. Further, the Monitor/Manager discovered one silver bar at another depository and another one at a trading firm. Moreover, the Monitor/Manager discovered precious metals in a safe located at Hunter Wise’s Irvine office, which appraised at just over a quarter of a million dollars.
In total, based on the Monitor/Manager’s preliminary estimates, less than $1.5 million in equity (i.e., approximately 3% of the $45 million that the retail customers were told they owned and 23% of the $6.3 million in total equity that Hunter Wise actually held and invested) was maintained in physical form and used by Hunter Wise as collateral to balance certain of the retail customers’ equity positions. The Monitor/Manager discovered that Hunter Wise invested the remaining equity primarily through accounts at trading firms, and the total equity (whether in trading accounts or in physical form) was used to achieve the 75% leveraged positions in those trading accounts. According to the Monitor/Manager, invested equity was never assigned to specific retail customers, or even dealer entities who would be entitled to the metals; however, Hunter Wise’s trading platform system would maintain an accounting of each client’s “equity” (i.e., the current market value of the customer’s investment after deducting amounts that the customer borrowed against that initial investment and the fees and commissions) and “excess equity” (i.e., the cash amount that was not invested by the customer and available for immediate withdrawal, and that was above the margin call amount required to be maintained by the customer as part of his or her leveraged transaction).
Significant Losses Sustained by Nearly All Retail Customers
The Monitor/Manager obtained significant amounts of data from Hunter Wise’s offices, amongst which were tabulations of all sums invested, fees (interest and service fees, miscellaneous fees and commissions) charged to dealers and passed along to retail customers, sums withdrawn, and net amounts gained or lost on the investment. The numbers speak for themselves. From the inception of the business in 2008 through March 6, 2013, the Monitor/Manager discovered that Hunter Wise received nearly $150 million in total customer investments. After accounting for withdrawals made, the Monitor calculated that customers invested a total net amount of just over $90 million with Hunter Wise by and through its network of dealers. During the same time period, according to the Monitor/Manager, Hunter Wise customers were charged nearly $35 million in commission spreads, nearly $8 million in interest, a little more than that in services fees, and nearly $350,000 in miscellaneous fees, for a total sum of fees and commissions charged in excess of $50 million.
Further, the Monitor/Manager learned that retail customers also suffered significant trade-related losses (during this time period) of nearly $33 million. Indeed, the Monitor/Manager determined that almost all customers (93%) sustained trade-related losses on their investments, with more than 39% of their overall sustained losses attributable to trade-related losses. And, the trade-related losses that customers sustained were compounded many times over by the high commissions and fees that Hunter Wise and its dealers charged. In fact, the Monitor/Manager concluded that Hunter Wise and its dealer network’s revenues were responsible for more than 61% of overall losses sustained by customers. The Monitor/Manager’s investigation revealed that, from the effective date of the Dodd-Frank Act in mid-July of 2011 through early March of 2013, customers invested more than $97 million and were charged in excess of $25 million in total fees. And, more than 61% of customers’ overall loss can be attributed to such exorbitant fees.
Moreover, the Monitor/Manager concluded that, since the inception of Hunter Wise’s operations in 2008, more than 91% of all customer net funds invested were lost to fees and trade-related losses. And, since mid-July (when the Dodd-Frank Act became effective), 88% of all customer net funds invested were lost to fees and trade-related losses. Evidently, the Dodd-Frank Act’s becoming effective did not persuade Hunter Wise or its dealers to change their business or trading practices. Indeed, the principals maintain the position that their business structure was legal and continue to defend against the CFTC’s claims. Therefore, according to the CFTC, commencing the Hunter Wise Action was necessary to protect existing retail customers from sustaining further losses, to facilitate the recovery of those losses, and to prevent future customers from incurring comparable losses. Defendants, on the other hand, assert that the Dodd-Frank Act does not apply to Hunter Wise’s business plan or trading practices, which they claim were neither illegal nor the cause of the customers’ losses.
Status of Monitorship and Litigation
In periodic reports to the District Court, letters to the retail customers, and on the website established to keep customers and creditors of Hunter Wise informed of the status of the monitorship (www.hunterwisemanager.com), the Monitor/Manager reported all of the foregoing findings and determinations, the details of her investigation into the operations and assets of Hunter Wise and its dealers, and her efforts to marshal and secure their assets and carry out the other directives under the Appointment Order and the Injunction Order. The Monitor/Manager determined that Hunter Wise’s business plan and operations were not viable and recommended that the District Court convert the monitorship to a receivership so that a claims administration process and a distribution plan could be instituted and customers could recover some of their losses. With respect to the status of litigation in the Hunter Wise Action, discovery has essentially been concluded, the parties have filed motions for summary judgment, which the Court has not yet ruled on, and the trial is currently set to commence in the beginning of December 2013.
*Kenneth Dante Murena is lead counsel to the Monitor/Manager in the Hunter Wise Action. He is a partner at the law firm of Damian & Valori, LLP (www.dvllp.com), a litigation, receivership and bankruptcy boutique law firm located in Miami, Florida.
The majority of Kenneth’s practice consists of representing Federal and State Court-appointed receivers, monitors, distribution agents and other fiduciaries in securities and commodities litigation matters, government enforcement actions and corporate and real property disputes. He also routinely represents bankruptcy trustees and creditors in Chapter 11 and Chapter 7 bankruptcy cases and adversary proceedings, and litigants in complex business and fraud litigation matters.
Kenneth was admitted to the Florida Bar in 1998 and is licensed to practice law in all state and federal courts in the State of Florida and the United States Courts of Appeals for the Third and Eleventh Circuits. Kenneth is an associate member of NAFER.
 See Public Law 111-203, 124 Stat. 1376 (2010), codified at 7 U.S.C. §§ 6(a), 6(b), 9 and 15.
 As amended by the Food, Conservation and Energy Act of 2008, Pub. L. No. 110-246, Title XIII (the CFTC Reauthorization Act of 2008) §§ 13101-13204, 122 Stat. 1651 (enacted June 18, 2008) and by the Dodd Frank Act, codified at 7 U.S.C. §§ 6(a), 6(b), 9 and 15 and the CFTC regulations promulgated thereunder, 17 C.F.R. 1.1 et seq. (2012).
 For purposes of the Hunter Wise Action, the CFTC contends that a “retail customer” is a person that is not an Eligible Contract Participant (“non-ECP”) as defined at section 1a(18)(A)(xi) of the Commodity Exchange Act, 7 U.S.C. § 1a(18)(A)(xi), and that Defendants’ retail customers do not have the $5 million or more invested on a discretionary basis that is required to be an ECP.
 According to the CFTC, if a transaction is conducted on an “exchange” or “board of trade,” a regulated clearinghouse takes the opposite side of a customer’s transactions, which eliminates the risk of default by a private counterparty.
 Section 753 of the Dodd-Frank Act amended section 6(c) of the Commodity Exchange Act at 7 U.S.C. §§ 9 and 15, broadening the CFTC’s anti-fraud jurisdiction as set forth in Commission Regulation 180.1, 17 C.F.R. § 180.1.
 See Section 742(a) of the Dodd-Frank Act, adding section 2(c)(2)(D) to the Commodity Exchange Act.
 See id.
 See Sections 4(a), 4(b), 4(d) and 6(c) of the Commodity Exchange Act, 7 U.S.C. § 13a-1, as amended by 7 U.S.C. §§ 6(a), 6(b), 9 and 15.
 CFTC Regulation 180.1, 17 C.F.R. § 180.1.
 See Section 6(c) of the Commodity Exchange Act, 7 U.S.C. § 13a-1.
 See Notes 4 and 5, supra.
 The Monitor/Manager recovered de minimis quantities of gold and silver bars and coins, and fashion watches from Hunter Wise’s leased condominium unit in Santa Ana, California.
 This amount is an estimate based on the prevailing spot prices of the precious metals in the accounts the date the metals were discovered in March of 2013, and does not account for the numismatic value of certain items in inventory.
 The value of these metals is based on market spot prices on the date of the appraisal in March of 2013.
 The estimated value of the equity held in physical form is based on the spot prices of precious metals as of the date of their appraisal in March of 2013. Further, the amount of total equity that Hunter Wise held and invested excludes cash on hand at various bank accounts of Hunter Wise that the Monitor/Manager discovered, as well as the sums of indebtedness by affiliate entities or owner managers of Hunter Wise that have been paid to the Monitor/Manager.