Binary options offer investors the opportunity to earn enormous returns quickly. With the potential large upside, however, comes the risk of substantial losses. Although binary options are not new products, the US Department of Justice (DOJ), US Securities and Exchange Commission (SEC) and US Commodities Futures Trading Commission (CFTC) have recently displayed a commitment to increasing resources to investigating and prosecuting bad industry players. In the past few weeks alone, regulators have charged over half a dozen individuals and entities for defrauding binary options investors. These charges represent the latest in a recent ramped-up effort to curb abuses in the binary options market. Domestic and foreign market participants should pay attention to these developments and review their practices and procedures to minimize the risk of running afoul of the DOJ, SEC and CFTC.
Binary options are a type of option contract in which the payout depends entirely on the outcome of a yes or no proposition. Typically, the proposition relates to whether the price of a particular asset, often a commodity or security, will be above or below a specified amount at a certain date and time. Binary option contracts execute automatically. Accordingly, once an investor acquires the option, there is nothing additional the investor must do in order to exercise the contract. Unlike other types of option contracts, binary options do not entitle an investor to own the underlying asset. If a binary option expires “in the money,” a holder will earn a pre-determined amount of money, generally up to 50 percent of the investment. If, however, the binary option expires “out of the money,” customers often risk losing their entire investment.
The ecosystem of the binary options industry and its offerings has grown substantially in recent years. That growth, however, has brought with it many non-compliant actors who market and sell binary options to US investors. For example, although some binary options are traded on designated exchanges overseen by the SEC or CFTC, a portion of the market functions through brokers operating online trading platforms and boiler rooms that are not necessarily complaint with applicable US regulations. A recent spike in investor complaints has caused regulators to increase resources dedicated to investigating and prosecuting these non-compliant platforms and brokers. Investor complaints generally fall into the following categories: (i) refusal to credit customer accounts or reimburse funds to customers; (ii) identity theft; and (iii) manipulation of software to generate losing trades.
Role of the regulators
Regulators' different missions and authority drive their distinct, but related, investigations and prosecutions. The SEC, charged with regulating securities markets, generally focuses on binary options brokers to determine whether the brokers or platforms are properly registered and provide the requisite risk disclosures. The CFTC, which is responsible for regulating derivatives markets, reviews binary options brokers to ensure that they are properly registered. The CFTC also assesses whether binary options contracts are sold in designated markets and only to qualifying investors with a net worth of at least $5 million. The DOJ, whose mission includes enforcing the nation's criminal laws, investigates, and if necessary, prosecutes binary options market participants who engage in fraudulent practices, including misleading investors or misappropriating their investments.
Recent enforcement trends
Since late 2018, the SEC has sued over 20 individuals and entities in federal district court enforcement proceedings for deceiving investors through the sale of binary options. According to the SEC, most of these individuals' operations entailed one or a combination of (i) targeting vulnerable, unsophisticated investors, including the elderly and millennials; (ii) using high pressure sales tactics, frequently conducted out of foreign boiler rooms; (iii) under-representing investors' risk of loss; (iv) failing to disclose that the broker often served as a counter-party to investors' binary options contracts such that the broker's gain relied on the investors' loss; and (v) using software to manipulate investors' trading results to increase investor losses and increase broker gains.
During the same time period, the CFTC has sued dozens of individuals and entities for (i) operating unregistered binary options brokerages and platforms; (ii) selling unregistered, and sometimes fraudulent or misleading, binary options contracts and (iii) selling binary options to unqualified investors. To add extra protections to consumers, the CFTC has established and maintains a Registration Deficient List, aka the RED List, that lists foreign entities acting as binary options brokers in an unregistered capacity.
But, perhaps most challenging for participants in the binary options industry is that the DOJ, often working with the SEC and CFTC, has ramped up criminal investigations and prosecutions of individuals who engage in illegal binary options practices. Prior to 2018, it does not appear that the DOJ had invested substantial resources in investigating and prosecuting individuals for crimes related to binary options. Since April 2018, however, the DOJ has charged at least half a dozen individuals for engaging in unlawful binary options trading practices. Generally, the DOJ has charged these individuals with wire and securities fraud related to their alleged (i) misrepresentations about the risks associated with binary options trading; (ii) misrepresentations to customers that their financial interests, as brokers, was adverse to customers' interests; and (iii) use of software to manipulate the results of trades to the benefit of brokers but detriment of their customer-investors.
While binary options contracts are not per se illegal, brokers and marketers must ensure that their contracts, platforms and sales and marketing practices comply with regulatory requirements. Historically, the binary options industry largely avoided the attention of regulatory and enforcement authorities. Now, however, the SEC, CFTC and DOJ are increasingly monitoring, investigating and prosecuting industry players for a range of violations. We expect this focus to continue.
While increased oversight is necessary to protect investors and improve market function, it will, necessarily, result in increased attention on even compliant actors. Laws and regulations governing binary options are complex. Market participants should assess their activities related to binary options to make certain that they are complying with all relevant regulatory requirements before they receive a regulatory inquiry. Market participants who identify potential compliance issues should work to correct those issues.
Finally, individuals and entities based abroad but who have sold investments to US investors are also subject to US law enforcement's jurisdiction and extradition tools. These foreign actors, should consult with experienced US legal professionals to discuss their risks and responses to government inquiries and prosecutions.
For more information on this topic please contact either of the authors.