First DOJ NFT insider trading fees mark new enforcement time

The Ministry of Justice is stepping up enforcement efforts with regard to the marketplace for non-fungible tokens (NFT), and recently issued the first ever indictment against a person for an alleged insider trading in digital assets.

Even with this increased enforcement, the DOJ will have to rely on the NFT community and reputable market experts to keep up with the development sector.

The allegations in the DOJ’s indictment against Nathaniel Chastain on May 31, a former employee of OpenSea, the world’s largest NFT marketplace, came to the government’s attention from members of the NFT community, for example.

The government claims that Chastain, who was responsible for selecting NFTs to be displayed on OpenSea’s website, bought the NFTs before they were put out to tender. He is charged with fraud and money laundering.

The money laundering allegation claims that Chastain used anonymous accounts in the marketplace to hide his identity and transmitted NFTs via hot wallets (cryptocurrency wallets that are always connected to the internet) to avoid being caught. Chastain’s alleged activity was first discovered by the NFT community, which was able to track the transfer of NFTs and funds back to his public account.

Meanwhile, the electronic fraud charge has aroused interest because the word “securities” is missing in the allegations. The case may clarify in the NFT sector which transactions involving NFTs are to be categorized as securities during the Howey test, which is used to determine when a transaction is subject to US securities laws.

The DOJ claims that Chastain invested money in NFT projects in the expectation of selling the NFTs at a profit. The claims, if they turn out to be true, could extend the class of NFTs considered securities – a far departure from the popular misconception of NFTs as mere digital images.

Evolution of NFTs

In recent years, NFTs have evolved from primarily collectible digital images to blockchain representations of ownership rights. NFTs are now used more often as part of the interest in a marketplace that may be linked to a collection of physical or digital things. The value of these NFTs is often determined by the liquidity in the markets and the marketing knowledge of project and marketplace managers – third parties – rather than as a simple resource.

As NFTs continue to expand beyond art and digital collectibles, marketplaces will continue to be established to accommodate the various types of NFTs entering the blockchain. In addition, existing marketplaces are expanding their opportunities to accommodate new varieties of NFTs. While many NFT trading platforms have implemented policies and procedures that govern when their employees can buy or sell NFTs featured on their marketplaces, their ability to enforce these guidelines is often limited due to employees’ potential to create hot wallets.

The DOJ, the Securities Exchange Commission, the Commodity Futures Trading Commission (CFTC) and other agencies responsible for controlling insider trading are in a better position to examine individuals who use their respective positions for profit given their expertise and resources. As mentioned above, however, the NFT community is an invaluable resource for both companies and investigators.

Current enforcement status

The DOJ is well aware of the potential for fraud in the NFT area and has already exercised its enforcement power over the NFT industry. Two months ago, The DOJ charged two people with conspiracy to commit electronic fraud and conspiracy to commit money laundering as a result of an NFT project. The organizers are said to have misused the funds received by wallets under their control and left the project before giving the announced incentives. The same people allegedly planned to start a second NFT project with the same intention, but the DOJ indictment stopped them before the second project was released.

To meet the rapid expansion of cryptocurrencies and NFTs, the DOJ established the National Cryptocurrency Enforcement Team (NCET) in February. Eun Young Choi, an experienced prosecutor with almost ten years of experience, was appointed its first director. Choi was instrumental in the prosecution of Silk Road founder Ross Ulbricht, which resulted in his life sentence. Silk Road was a dark web marketplace that existed from 2011 to 2013 that allowed users to buy illegal items such as drugs, weapons and even exotic animals anonymously through payments with bitcoin.

In addition to Choi’s expertise and leadership, NCET has openly announced that it will rely on the private sector to assist in overseeing the NFT industry. In particular, there are already countless social media accounts dedicated to investigating NFT projects and tracking suspicious activity. Many of these industry experts (and perhaps some self-proclaimed experts) have hundreds of thousands of followers, enabling extensive dissemination of information. By working with these authors and resource aggregators, DOJ hopes to oversee a larger share of the market.

An overwhelming majority in the NFT community believes that state supervision is necessary. Thousands of scams occur every day with little recourse for those whose digital assets are stolen. The information differences are still lush. The DOJ and other government agencies recently increased their efforts through the formation of units focused on cryptocurrencies, but this effort must be expanded.

As with this first NFT insider trading indictment, the DOJ will have to rely, at least in part, on the NFT community to alert them to suspicious activity to ensure fairness as the usefulness of NFTs grows.

This article does not necessarily reflect the intent of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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John Cahill is an associate attorney at Wilson Elser’s office in White Plains, NY. His practice focuses on cryptocurrencies, especially NFTs, and he examines current trends to ensure that clients comply with current and evolving legal restrictions.

Jana S. Farmer is a partner in Wilson Elser’s New York Metro offices. She leads the company’s practice for art law, and is a member of the company’s practice for intellectual property and technology. She focuses on the development, acquisition, licensing and exploitation of intellectual property, including in transactions involving NFTs.

William H. Behr is a partner at Wilson Elser’s New York office. He focuses on M&A, corporate and hedged financial transactions, art law, commercial transactions and corporate governance.