How to stay off DOJ’s, SEC’s Radar when dealing with NFTs

The Department of Justice, the Securities and Exchange Commission and other regulators are coming for non-fungible tokens.

Earlier this year, the DOJ indicted Nathaniel Chastain, a former employee of an NFT marketplace in what was the first NFT insider trading case. The SEC has also been busy, reportedly issuing subpoenas to NFT creators and crypto exchanges to determine whether NFTs are being used to raise money like traditional securities.

While many companies are understandably excited to explore and use Web3, the DOJ has been clear: “Web3 is not a lawless zone.”

Regardless of how a company wants to leverage NFTs – to trade or market products and engage users – they should take the time to understand (and address) the various regulatory risks surrounding NFTs in advance.

The DOJ and other regulators are intent on identifying and prosecuting illegal activity involving NFTs. A recurring theme in this work has been whether and when NFTs are securities.

NFTs are by definition non-fungible (ie unique). Because NFTs are not fungible, the DOJ and SEC may have difficulty determining that an NFT is subject to federal securities regulation.

Is it a security?

To date, neither the DOJ nor the SEC have directly addressed whether or when an NFT is a security. But that doesn’t stop the DOJ from pursuing illegal behavior historically associated with securities fraud.

In the Chastain case, the DOJ avoided the issue by choosing to prosecute using an wire fraud indictment rather than the securities laws traditionally used in insider trading cases.

But companies will not be able to circumvent securities laws simply by claiming that a digital asset is an NFT. As SEC Chairman Gary Gensler has said, the SEC “is not concerned with labels, but rather with the economic realities of an offering.”

State securities regulators have pursued enforcement action precisely on this basis. Despite a company’s claims to the contrary, the NFTs in question were considered securities and subject to regulation.

Although the SEC itself has not brought any enforcement actions involving NFTs, these are certainly on the horizon. The SEC’s announcement in May that it is expanding its crypto assets and cyber unit highlights its focus on NFTs.

In addition, earlier this year the SEC issued subpoenas seeking information about how NFT creators and crypto exchanges use NFTs, including fractional NFTs. These FNFTs, which are “fractions” of a single NFT, are more likely to be considered securities because, unlike NFTs, they are not unique and fungible.

Illegal activity

The DOJ may also fail to prosecute the use of (and failure to prevent the use of) NFTs to launder the proceeds of illegal activity. Bad actors often use expensive real estate and art to launder funds due to their high value, and NFTs can act as a similar conduit for large sums of money. For example, “The First 5000 Days”, an NFT created by artist Beeple, sold for $69 million in 2021.

Coupled with the relative anonymity of transferring NFTs on the blockchain, NFTs have the potential to be an effective mechanism for “cleaning” ill-gotten funds.

The DOJ may also take action against platforms that facilitate NFT transactions for not acting in compliance with anti-money laundering laws. The government has already suggested that such platforms may be subject to AML laws if NFTs are a “value that replaces currency”, and there is increasing pressure for legislation or regulation that expressly brings these platforms within their purview.

For example, Attorney General Merrick Garland is advocating for Congress to amend AML laws so that they unambiguously apply to platforms that sell NFTs. The government is also considering whether AML laws that apply to those engaged in “trading in antiquities” may extend to those engaged in NFT purchases, sales and transfers.

Stay out of trouble

Before diving into Web3 by exploring NFTs, companies should consider taking certain steps to try to stay off the radar of the DOJ and other regulators.

First, companies would do well to carefully evaluate their compliance program to ensure that it aligns with the DOJ expectations set forth in Evaluation for Corporate Compliance Programs.

Next, to avoid inadvertently issuing a security in the form of an NFT, businesses using NFTs (and digital assets in general) should consider whether the asset has characteristics that arguably make it a security. For example, a company may consider avoiding actions that may affect the NFT’s market price and prohibit the fractionation of NFT.

Finally, companies involved in facilitating NFT transactions should implement “Know Your Customer” policies and controls to ensure adequate due diligence. This includes sanction screening and transaction monitoring, carried out at onboarding and on an ongoing basis.

The DOJ and other regulators are focused on NFTs, and more NFT-related prosecutions and enforcement actions are inevitable. Taking steps now will help avoid problems down the road.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Andrea Gordon is an attorney at Eversheds Sutherland in the Washington DC office. She advises clients on white collar, compliance, SEC and FINRA matters.

Sarah Paul is a partner in Eversheds Sutherland in the New York office. Her practice spans all areas of white-collar defense, with a particular focus on governmental, internal and cross-border investigations, tax controversies, and cyber security and privacy law.

Adam Pollet is a partner at Eversheds Sutherland in the Washington DC office. He defends financial institutions, broker-dealers, investment advisers and individuals in regulatory investigations and enforcement matters involving the SEC, FINRA and state securities regulators.