Kraken, one of the world’s largest crypto exchanges, has been locked in a legal battle with Australia’s corporate watchdog, the Australian Securities and Investments Commission (ASIC), since September last year over a margin lending product. The Federal Court has now ruled that Kraken’s Australian arm, Bit Trade Pty Ltd, breached the far reaching design and distribution obligations (DDO) arising under the Corporations Act 2001 (Cth) (Corporations Act) by offering a margin extension product to retail customers without first preparing a Target Market Determination (TMD).
Kraken's Margin Extension product
Kraken's “Margin Extension” product allowed its users to buy cryptocurrency on margin, provided the user had a minimum balance of certain crypto-assets in their account to be used as collateral. Customers could receive an extension of up to five times the value of their collateral. Margin may be extended in fiat or digital currencies. If a customer's collateral fell below a required minimum, Kraken could sell the customer's crypto-assets and apply the proceeds to repay the margin extension such that the customer's collateral reached the minimum requirement. In the present case, the Court found that Kraken's terms also required the customer to repay margin extended in fiat currency in the same currency where they became ineligible to use the product.
The DDO and ASIC's case
Under DDO, the issuer of a financial product (and some products which aren't ordinarily financial products) must make a “target market determination” prior to the financial product being offered to consumers. A target market determination must, inter alia, describe the class of retail clients that comprises the target market for the product. The target market determination must be such that it would be reasonable to conclude that, if the product were to be issued or sold to a retail client in the target market, “it would likely be consistent with the likely objectives, financial situation and the needs of the retail client” (Corporations Act, s 994B(8)).
It was common ground between the parties that the product in question did not constitute a financial product for licensing purposes under Division 3 of Chapter 7 of the Corporations Act. However, ASIC argued that the Margin Extension product did meet the extended financial product definition which apply for the purpose of DDO obligations under Section 994AA of the Corporations Act (which refers to Division 2 Part of the Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act) and thus required the preparation of and publication of a TMD and implementation of accompanying systems and controls to ensure distribution of the product in accordance with the TMD.
The financial product definition in the ASIC Act includes a "credit facility". ASIC argued that:
when Kraken extended credit in the form of "national currency" (i.e., a fiat or sovereign currency), it created a deferred debt, effectively making the product a credit facility under the ASIC Act; and
that the obligation to repay cryptocurrency could amount to a credit facility for the purposes of the ASIC Act.
Kraken sought to rely on an exemption in reg 7.8A.20 of the Corporations Regulations 2001 (Cth) on the basis that the product was not in the nature of a deferred debt, but rather a "financial accommodation".
The judgment
Justice Nicholas agreed with ASIC's contention that an extension of margin repayable in national currency could constitute a deferred debt within the meaning of the ASIC Act and accompanying regulations, meaning Kraken’s margin product required the issuance of a target market determination defining the appropriate target market for the product.
However, his Honour also ruled that when credit was extended in crypto-assets, it did not amount to a deferred debt, on the basis that it did not involve an obligation to repay money (as crypto-assets are not money) and noting that a failure to repay may still sound in damages for breach of contract, rather than being directly recoverable as a debt.
The outcome and penalties
ASIC hailed the ruling as a victory, with Deputy Chair Sarah Court saying:
We initiated proceedings to send a message to the crypto industry that we will continue to scrutinise products to ensure they comply with regulatory obligations in order to protect consumers...
However, Kraken has signaled it will seek to rely on Section 1317S of the Corporations Act, which permits a court to relieve a party from penalties where a party has acted honestly and ought to be relieved of liability in all the circumstances.
This defence was recently relied upon successfully by Block Earner in its case against ASIC. That decision is now under appeal. The case nevertheless highlighted the need for product issuers, particularly those dealing in crypto-assets, to obtain early legal advice from a reputable firm before launching products or services in order to mitigate the risk of penalties in the event the product is later found to be a regulated offering.
ASIC’s initial case against Kraken kicked off in September 2023, after the regulator accused the exchange of operating without a TMD for its margin trading product, despite warnings. Kraken’s Managing Director, Jonathon Miller, voiced his frustration at the time in a statement to the Australian Financial Review, saying the company had been trying to work constructively with ASIC and otherwise underscored Kraken's desire for clearer regulatory guidance - a desire that is shared by the entire blockchain industry.
Reports of the difficulty of engaging with ASIC by other crypto-businesses are consistent with Mr Miller's comments, and it would seem a far more constructive use of scare taxpayer dollars for ASIC to engage in publishing clear guidance and good-faith engagement with crypto-businesses.
This case reflects ASIC’s outweighed scrutiny of crypto-asset related product offerings, and a willingness to continue testing the limits of their DDO powers in the absence of providing clear guidance or engagement to provide pathways to compliance for crypto-asset businesses, something which ASIC considers is not within it's remit.
In its latest media release addressing the Kraken decision, ASIC makes a strange assertion that:
Entities providing crypto-related products should be aware that many such products are financial products.
This kind of statement has appeared increasingly in ASIC communications in relation to recent enforcement and it stands in stark contrast to their submissions to the Australian Senate in 2017 that:
ASIC's view is that Bitcoins themselves (and other virtual currencies) are not financial products and are not regulated under the legislation we administer.
No explanation or reasoning has been provided for the change in position of evolution of thinking on ASIC's part and understanding the proper legal basis for this movement would be of great assistance to the industry as a whole and potentially avoid wasteful regulation by enforcement. Clear guidance and rule-making with pathways to compliance for crypto-asset products is essential if Australia is to harness the benefits of these innovations.
The outcome of Kraken's s1317S application, as well as the appeal from Block Earner's s1317S decision, will be closely followed by the industry as regulation by enforcement unfortunately continues in Australia.
A copy of the judgment can be found here.
By Luke Higgins, Steven Pettigrove and Michael Bacina
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