Mutual Owners, Mutual Funds: What We Know About the Bitfinex/Tether Scandal

In what seems to be one of the greatest crypto scandals 2019 has seen so far, the United States Attorney General in New York accused Bitfinex of using Tether’s cash reserves to cover a rumored $850 million funding gap with reserves meant for backing the stablecoin. Both companies share the same owner.

Now, the crypto exchange and the stablecoin have found themselves in hot water. At least $90 million worth of assets had left the Bitifinex wallets once the accusations were aired, while tether’s USDT peg remains almost unshaken.

Does the New York regulator have the legal rights to prosecute Bitfinex?

On April 25, the New York Attorney General’s (NYAG) office announced it was investigating iFinex Inc., the company that operates both Bitifinex and Tether. In the accompanying statement, Attorney General Letitia James accused the cryptocurrency exchange of losing $850 million and subsequently taking funds from Tether’s reserves to secretly cover the shortage.

Moreover, the state’s top prosecutor revealed that her office obtained a court filing alleging that iFinex and its associated entities were in violation of New York law in connection with activities that may have defrauded New York-based crypto investors. James stated:

“Our investigation has determined that the operators of the ‘Bitfinex’ trading platform, who also control the ‘tether’ virtual currency, have engaged in a cover-up to hide the apparent loss of $850 million dollars of co-mingled client and corporate funds. New York state has led the way in requiring virtual currency businesses to operate according to the law. And we will continue to stand-up for investors and seek justice on their behalf when misled or cheated by any of these companies.”

As per the court documents filed by Assistant Attorney General Brian Whitehurst, although iFinex is registered in the British Virgin Islands, it deals with some clients that are based in New York. Whitehurst subsequently highlights that neither Bitfinex nor Tether are licensed by the New York Department of Financial Services (NYDFS) to engage in virtual currency business in the state, while the agency “has promulgated regulations” within that field.

Selva Ozelli, international tax attorney and CPA, explained to Cointelegraph that the New York attorney general has jurisdiction over offshore matters under New York's Martin Act. According to Ozelli, the agency’s interest in cryptocurrencies might have arisen in September 2018, when the OAG published its Virtual Markets Integrity Initiative Report, which set forth the findings by the office about the practices of “virtual asset trading platforms” that operate — or were believed to operate — in New York. Among the findings, she says that the OAG highlighted the “substantial potential for conflicts between the interests of the platform, platform insiders, and platform customers.” She also added:

“An offshore company like Bitfinex could carry on of a U.S. trade or business depending on the nature and extent of its economic activities in New York which must go beyond a single isolated act or transaction and involve considerable, continuous, and regular activity."

Andrew Rossow, an attorney and law professor, also believes that the New York attorney general should have enough juridical power to get involved despite the fact that neither Bitfinex nor Tether is based in New York or has a BitLicense to operate there. He told Cointelegraph:

“There are two sources of law that allow for the New York Attorney General to get involved.

First, NYAG does have power as there is arguably a strong case for jurisdiction here. Under the law, the minimum contacts standard is used for determining whether jurisdiction exists.”

Rossow develops: “In this case, the NY AG believes that because Bitfinex is specifically availing itself to individual investors in New York, by means of allowing NY-based individuals to deposit, trade, and withdraw digital currencies, as well as engage in other transactions, there is sufficient contact within the State of New York to establish that jurisdiction. Therefore, with respect to protecting ‘its own,’ in this case, NY investors, the NYAG does in fact have power here.

“Second, the NYAG can invoke the ‘Martin Act,’ which broadly empowers the NYAG to conduct civil and criminal investigations for securities law violations. New York is a state that has demonstrated its leadership in this digital currency space, and therefore, has one of the most stringent state laws with respect to it. Obviously, with Wyoming’s Token Taxonomy Act (TTA), we have another powerful force on the field.”

Caitlin Long, the co-founder of the Wyoming Blockchain Coalition with previous experience of working for Wall Street banks, argued that the OAG showed double standards by using the Martin Act for the iFinex case while holding back when Merrill Lynch was doing something “quite similar” during the 2009-2012 period:

Cointelegraph has contacted Long for further comment, but has not received a reply as of press time.

The filings detail how the Office of the Attorney General started investigating Bitfinex and Tether in 2018

As part of the probe, the Office of the Attorney General (OAG) requested information from third-party entities, including banks and audit firms, that have allegedly been involved in business with iFinex. By November 2018, the counsels for Bitfinex and Tether — jointly represented by the law firms Morgan, Lewis & Bockius LLP and Steptoe & Johnson LLP — had reportedly found out about the investigation and contacted the OAG on behalf of their clients.

On Nov. 21, 2018 the companies’ lawyers and the OAG discussed the case for the first time via email. The representatives of Bitfinex and Tether reportedly said they would provide documents and information to the OAG if the corresponding subpoenas were served. On Nov. 27, the OAG allegedly presented the subpoenas. The lawyers of Bitfinex then accepted the writ and began producing documents.

Three months later, on Feb. 21, the OAG and the counsels for Bitfinex and Tether held a meeting to discuss the investigation in person. At the meeting, Whitehurst claims, the representatives of the crypto companies explained to the OAG that Bitfinex has “had a succession of unsuccessful banking relationships around the world over the past several years” because many financial institutions have been reluctant to do business with “unregulated or off-shore companies” involved in cryptocurrencies.

Specifically, as per the court document, prior to 2017, Bitfinex and Tether “had used several Taiwan-based banks to make and receive wire transfers to fulfill client orders for U.S. dollars. and for other purposes,” with Wells Fargo acting as the correspondent bank. In March 2017, Wells Fargo allegedly declined to process U.S. dollar transfers from Bitfinex and Tether accounts. The companies were therefore forced to quickly find alternative arrangements, which is why they filed (but soon withdrew) a lawsuit against Wells Fargo, arguing that the bank’s decision "presented an existential threat to their business."

In November 2018, Tether publicly announced establishing a banking relationship with Deltec Bank & Trust Limited, a Bahamas-headquartered entity. In the same statement, Tether also claimed that "USDT in the market are fully backed by US dollars that are safely deposited in our bank accounts."

However, the prosecutors argue that Bitfinex never publicly disclosed its relationship with a Panama-based firm called Crypto Capital Corp., which supposedly started as early as 2014.

According to Whitehurst, Crypto Capital acted as a “payment processor” for Bitfinex and Tether, handling over $1 billion of its commingled customer and corporate funds, however “no contract or similar written agreement was ever entered into between Crypto Capital and Bitfinex or Tether.” Other “payment processors” reportedly included “friends" of Bitfinex, which the OAG describes as “human being friends of Bitfinex employees that were willing to use their bank accounts to transfer money to Bitfinex clients who had requested withdrawals.” As per the court document, prosecutors believe that the crypto exchange used the services of those payment processors because it had no reliable bank to work with.

Notably, the court filings feature alleged communication logs covering the period of April 2018 to early 2019 between a senior Bitfinex executive ("Merlin") and an individual at Crypto Capital ("Oz"), which were allegedly produced for the OAG by the attorneys of Bitfinex and Tether.

According to the enclosed conversation, Bitfinex was experiencing severe problems with its clients’ withdrawals requests, as the crypto exchange essentially had no money to foster to them.

Thus, Whithurst writes that in October 2018, rumors began circulating online that Bitfinex clients were unable to withdraw their money. The same month, the crypto platform published a number of public statements suggesting that such hearsay was "a targeted campaign based on nothing but fiction." Specifically, on Oct. 15, 2018, Bitfinex announced that “all cryptocurrency and fiat withdrawals are, and have been, processing as usual without the slightest interference.” According to the OAG, “that was untrue,” because on the same day, the senior Bitfinex executive ("Merlin") supposedly wrote to his contact at Crypto Capital that “too many withdrawals waiting for a long time,” which is why he urgently needed the money from Crypto Capital, “in Tether or any other form.”

“Please understand all this could be extremely dangerous for everybody, the entire crypto community,” Merlin reportedly said.

“BTC could tank to below 1k if we don’t act quickly.”

Indeed, as Cointelegraph wrote around the time, Bitfinex had to temporarily halt fiat deposits in four fiat currencies — euro, U.S. dollar, Japanese yen and British pound — without specifying a reason for the suspension.

According to the documents cited by the investigators, at some point, an unidentified Crypto Capital representative explained to the senior Bitfinex executive that $851 million could not be returned to the crypto exchange because it had been seized by governmental authorities in Portugal, Poland and the U.S. Bitfinex and Tether lawyers reportedly told the OAG that their clients do not believe that the money had actually been confiscated.  

“Line of credit”: how Bitfinex (allegedly) used Tether’s reserves

At the same meeting in February, Whitehurst writes, the lawyers of Bitfinex and Tether said that their clients “were in the process of contemplating a transaction that would permit Bitfinex to draw upon Tether's cash reserves on an as-needed basis” in order to cover the missing $851 million.

Specifically, the filing states, the counsels explained that Bitfinex would take a "line of credit" of $600 to $700 million on the reserve funds backing tether. When asked by the OAG whether such a transaction would represent a conflict of interest given that Bitfinex and Tether are owned and operated by the same people, the lawyers reportedly described the planned deal as "arm's length." That “raised serious questions about the viability of Bitfinex as an ongoing concern, the possibility that Tether's cash reserves would be dissipated and unrecoverable, and whether Bitfinex and Tether have misled their clients,” Whitehurst writes in the document.

Soon after the meeting took place, the prosecutors allegedly requested Bitfinex and Tether to provide more information on the contemplated transaction before March 7. Three days prior to that deadline, the companies’ representatives allegedly told the OAG that it was not possible to get this information in time. On March 11, and then on March 19, the respondents finally forwarded documents that, according to the OAG, turned out to be either blog posts by Bitfinex and Tether that had already been posted online or other information that was not relevant to the aforementioned “line of credit” transaction.

On March 29, the representatives of Bitfinex and Tether purportedly informed the OAG that the transaction had already taken place two days before. As per the document, they also described a previously undisclosed transfer of $625 million from Tether's reserves to Bitfinex that allegedly took place in November 2018:

“During November 2018, Tether transferred $625 million held in its account at Deltec to Bitfinex’s account at Deltec. Bitfinex, in turn, caused a total of $625 million to be transferred from Bitfinex’s account at Crypto Capital to Tether’s account at Crypto Capital, through a ledger entry at Crypto Capital crediting Tether’s account in the amount of $625 million and debiting Bitfinex’s account by a corresponding amount. The purpose of this exchange was to allow Bitfinex to address liquidity issues unrelated to tethers.”

Neither deal had been disclosed to investors or customers, the prosecutors stress.

Therefore, the OAG's ongoing investigation aims “to determine, among other things, the extent to which New York investors are exposed to ongoing fraud being carried out by Bitfinex and

Tether.”

Now, the court has reportedly ordered the operators of the companies to immediately cease the dissipation of the U.S. dollars that back tether tokens and to produce investigation-related information and documents. The ruling also prohibits the companies from destroying potentially related documents.

It is still unclear whether the missing funds belong to the company