What You Need to Know About Cryptocurrency Pump-and-Dump Schemes

Cryptocurrency exchanges provide new and additional markets and methods to facilitate pump-and-dump schemes. Scammers utilize both traditional and novel implementation programs.

 New Jersey Law Journal   January 07, 2022

By Jonathan Bick      Jonathan Bick is counsel at Brach Eichler in Roseland, and chairman of the firm’s Patent, Intellectual Property & Information Technology group. He is also an adjunct professor at Pace and Rutgers law schools.

Cryptocurrency pump-and-dump schemes (CPDs) are becoming increasingly prevalent. As in the case of traditional “pump and dump” schemes, CPDs lead to short-term trading perturbations—exaggerated increases and/or decreases in prices, volume, or volatility. Prices peak or bottom out within a short time span and are usually accompanied by quick reversals, resulting in a manipulated inflation or deflation of an asset’s price, usually accomplished via misleading recommendations. Since the inception of cryptocurrency as a widely traded asset, there has been increasing opportunity to make money through market manipulation, specifically through classic pump-and-dump and related fraudulent schemes, and more specifically CPDs.

While pump-and-dump schemes are common in traditional financial markets, cryptocurrency exchanges provide new and additional markets and methods to facilitate this practice. Though CPDs are new, CPD scammers utilize both traditional and novel implementation programs.

Traditional CPD programs employ email spam campaigns, social media fake press releases, and telemarketing. Novel CPD implementation programs vary widely, but they commonly include buying or selling crypto futures at above or below market in a particular cryptocurrency, and then spreading positive or negative rumors, typically via Discord and other apps, about said cryptocurrency in an attempt to manipulate its value.

In all cases of CPDs, the value of a particular cryptocurrency is deliberately altered by the perpetration of an unlawful activity. These unlawful activities include but are not limited to hacking smart contracts (resulting in publishing a series of incorrect cryptocurrency values), virtual currency Ponzi schemes (as disclosed by the SEC Investor Alert, (153), 2017), “short and distort” programs (i.e., spreading negative information to drive the price down), and the use of digital tokens (which have no underlying cash flow or real fundamental economic value).

Since at least as early as 2009, virtual currencies and digital tokens have been in use, and various United States agencies have attempted to regulate them. These uses have taken the form of peer-to-peer transactions, open-source ledger technology securities, commodities, and assets that could not be defined using existing regulatory definitions and therefore did not neatly fit into existing regulatory efforts.

However, in 2015 the United States Commodity Futures Trading Commission (CFTC) came forward and defined Bitcoin and other virtual currencies as commodities under the United States Commodity Exchange Act (the CEA). The CFTC, which is authorized to take enforcement action against both registered and non-registered entities, began regulating cryptocurrency derivative markets including futures, options, and swaps. It has brought suit against at least 15 entities for CPDs that violated the CEA and/or the CFTC Regulations. 

Under the CEA, the CFTC has jurisdiction over retail commodity transactions unless “actual delivery” occurs within 28 days of execution (see 7 U.S.C. §2(c)(2)(D)). Most crypto entities hold the object of the crypto transactions for the benefit of the customer in an omnibus settlement wallet, which is accounted for in real time on an accessible database. Since the omnibus settlement wallets are owned and controlled by crypto entities which hold all “private keys” associated with its omnibus settlement wallet, courts have found that no “actual delivery” occurs. Thus, the crypto entities had violated the retail commodity transaction rules by providing for the execution and confirmation of retail commodity transactions without having such transactions occur on or subject to the rules of a CFTC-regulated exchange.

The courts confirmed the CFTC’s authority and the scope of its cryptocurrency regulatory range in In the Matter of: Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan, CFTC Docket No. 15-29. 2015 WL 5535736 (Sept. 17, 2015), and others. More specifically, these actions involve CPD facilitated by fraud (fraudulent solicitation, misappropriation of funds, issuing false account statements, Ponzi schemes, affinity schemes) and market manipulation, including attempted market manipulation and disruptive trading practices (for example, fictitious and non-competitive transactions, attempts to manipulate prices, and spoofing, which is defined as entering an order with the intent to cancel it before it is consummated in a complete transaction). 

Additionally, to counter CPD activity, in 2021 the CFTC, relying on authorization granted by the Dodd-Frank Act, initiated a whistleblower program. This program makes whistleblowers eligible for a monetary reward of between 10% and 30% of the government recovery if the enforcement action leads to monetary sanctions of $1 million or more against a pump-and-dump scheme.

CPDs, like traditional pump-and-dump schemes, are illegal under a number of federal and state statutes, depending on the specifics of the case. For example, if the CPD transaction required the use of a security which was listed on a United States exchange or purchased in the United States, then the Securities Act of 1933 (Section 17 (A)) makes issuing a security using “any device, scheme, or artifice to defraud” or “any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made” unlawful. Thus, CPD transactions result in a per se violation of these statutes. 

Other statutes may be applicable for CPD transactions involving securities, including the Securities Exchange Act of 1934. If the CPD transactions also incorporate mail, wire, television, or radio elements, they would then violate 18 U.S. Code Section 1341 or 1343. Additionally, if the CPD transaction involves securities, an 18 U.S. Code Section 1349 violation would arise. Alternatively, a Section 10(b) fraud claim may be applicable, as this section prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. 

It is important to note that the focus of the Securities and Exchange Act of 1934 is not upon the place where the deception originated, but upon purchases and sales of securities in the United States. As found by the court in Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010), the Act does not punish deceptive conduct, but only deceptive conduct in connection with the purchase or sale of a security. 

State law may become more of a factor for prosecuting CPDs. The U.S. Court of Appeals for the Second Circuit (Barron v. Helbiz Inc., Case No. 21-00278) vacated and remanded a district court’s finding that dismissed non-securities state law claims in connection with an Initial Coin Offering (Barron et al v. Helbiz, Inc. et al, No. 1:2020cv04703 (S.D.N.Y. 2021)) because it found that the lower court should have taken a more tailored approach when considering a transaction which could be considered a CPD using New York state law, though both courts agreed as to the general applicability of Morrison.