The increase in financial crime in the NFT market prompts new scrutiny from regulators | Proskauer – Blockchain and the Law

With the enduring popularity of certain NFTs and the promise of use in the metaverse and beyond, the hype surrounding the new technology has been accompanied by growing concerns that NFTs are at the center of traditional financial crimes such as money laundering and wire fraud. For example, on June 30, 2022, the Department of Justice indicted six people in four separate cryptocurrency fraud cases, which together involved over $130 million of investors’ funds. These indictments include allegations of a global Ponzi scheme selling unregistered crypto-securities, a fake initial coin offering involving fake associations with top companies, a fraudulent investment fund that allegedly traded on cryptocurrency exchanges, and the largest known Non-Fungible Token (NFT) money laundering scheme to date .

In one of those cases, the defendant, Le Anh Tuan, a 26-year-old Vietnamese citizen, was charged in California with one count of conspiracy to commit wire fraud and one count of conspiracy to commit international money laundering involving “Baller Ape » NFTs. . (United States v. Tuan, No. 22-cr-273 (CD Cal. Indictment June 28, 2022)). In an attempt to capitalize on the popular Bored Ape Yacht Club, the defendants launched the Baller Ape Club, featuring “Baller Ape” NFTs featuring characters in various outfits decorated with colorful prints. According to the indictment, Tuan and unnamed co-conspirators first accessed investors’ digital wallets and processed token transactions and then “rug-pulled” investors shortly after Baller Ape Club’s public sale began by terminating the alleged project without notice and shutting down its website. . In total, it was alleged that around $2.6 million was stolen. To hide the stolen funds, the defendant allegedly laundered the money through “chain hopping”, a money laundering scheme where funds are moved across multiple cryptocurrency blockchains and decentralized cryptocurrency exchange services are used to hide the trail of the stolen funds.

United States v. Tuan is just the latest case of crime to rock the NFT world. Earlier in June, Nathaniel Chastain, a former product manager at OpenSea, was indicted in New York in the first NFT scheme for insider trading in digital assets. (United States v. Chastain, No. 22-cr-305 (SDNY Sealed Indictment May 31, 2022)). OpenSea is the largest online marketplace for buying and selling NFTs. Chastain allegedly launched a scheme by misusing her knowledge of confidential information to secretly purchase dozens of NFTs before they were prominently featured on OpenSea. As part of the leadership team, Chastain was responsible for selecting NFTs to be featured on OpenSea’s website; OpenSea kept these special NFT picks confidential until they were published, as a main page entry often translates into a jump in prices. After the NFTs were featured, Chastain allegedly sold them for a profit of two to five times the original purchase price. Running the alleged scheme from June 2021 to September 2021, some reports stated that Chastain appeared to make a total profit of 18,875 ETH or $67,000 back in September 2021 (not a huge number given that news outlets were reporting at the time in As of August 2021, OpenSea had a sales volume of $4 billion). To hide the fraud, he allegedly conducted these transactions using anonymous digital cryptocurrency wallets and OpenSea accounts. The DOJ framed the charges against Chastain as one count of wire fraud and one count of money laundering, and sought forfeiture of any criminal proceeds, among other relief.[1]

These recent offenses relating to NFTs raise a number of legal questions regarding the status of NFTs. Chief among these concerns is the legal uncertainty over whether existing securities laws apply to the new world of digital assets. (Note: The uncertainty surrounding NFTs and intellectual property protection is another matter, which is the subject of a related post.) Insider trading is traditionally the basis for fees associated with securities transactions. However, NFTs are often considered to be digital collectibles and investment-grade digital artworks as opposed to securities, and to date there has been a notable lack of legal precedent around digital assets in general that could provide some clarity. As such, it was unclear until Chastain’s indictment whether prosecutors would even address Chastain’s alleged trading behavior back in September 2021. Despite the headlines and the “insider trading” label, the Chastain indictment by the DOJ was not based on securities laws or insider trading. trading rules, and is actually based on fraud claims as opposed to violations of the Securities Act. Given the way the indictment was framed in the Chastain case—the word “security” does not appear in the indictment—the indictment falls more under the general category of alleged financial crime than a violation of securities law. Indeed, as U.S. Attorney for the Southern District of New York Damian Williams noted, “NFTs may be new, but this type of criminal scheme is not.” With new technology platforms and investment opportunities available, money laundering and deceptive trade practices are both age-old problems that will always arise in today’s modern context.

In the absence of clear guidance on the regulatory status of NFTs, a bipartisan group in Congress has attempted to provide clarity through the recently proposed Act on responsible financial innovation (RFIA), comprehensive bipartisan legislation that seeks to create a complete regulatory framework for the management of digital assets. The RFIA seeks to clarify the respective jurisdictions of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) over digital assets. If passed, the bill would provide more regulatory clarity in determining whether a digital token is a commodity or a security, and among other things, by proposing that the majority of digital assets (subject to exceptions) be classified as regulated commodities from the CFTC. As a report on the bill to Congress noted, “The RFIA would limit the SEC’s jurisdiction over digital assets as the agency currently envisions it.”

Despite the potential review of the RFIA, it is important to note that the SEC has previously stated that NFTs can still be considered securities if they pass ‘Howey Test,’ which establishes that an “investment contract” exists when there is an investment of money in a joint venture with a reasonable expectation of profit to be derived from the efforts of others. SEC v. WJ Howey Co .328 US 293 (1946). The SEC generally looks at ‘Howey Test’ together with the nature of the transaction rather than the commodity being sold to determine whether an investment contract exists. Even if certain digital assets were treated as commodities under a new legal regime that has an expanded CFTC role, the SEC will likely still seek to regulate digital assets that it believes are used to raise money in the same way as a traditional security or are aggregated and fractionated into securities over digital assets. As such, we are left to wonder how digital assets and NFTs might be regulated and how the roles of the CFTC and SEC would be balanced under a comprehensive digital asset law. Although Chairman Gensler recently commented on the RFIA bill, he is concerned that deregulating certain digital assets or removing them from the SEC’s jurisdiction could create loopholes or “undermine” the overall regulation of the markets.

As revealed by OpenSea and the “Baller Ape” NFT indictment, the decentralized nature of blockchain and its transparent ledger can at times facilitate criminal activity and also expose it. Taking advantage of these innate features of blockchain technology while increasing responsible regulation by the SEC or CFTC can help foster a more robust yet safer crypto space. At the same time, however, the increased regulation could also work against the spirit of the crypto world, where many investors have turned precisely because of the lack of regulation in the hope of making their fortunes.

[1] Within the uncertain legal climate surrounding digital asset regulation, several news sources have pointed out that this type of behavior may be much more common than expected. Some traders, unlike Chastain, may simply be more cautious and better at hiding their tracks. An NFT trader and creator, Fedor Linnik, confided that insider trading can happen in popular projects with 10,000 profile picture-style NFTs. Initial purchasers of a newly minted NFT collection cannot discern the characteristics or valuable rarities unique to their own NFT prior to disclosure, allowing a gap in time for creators to know which undisclosed NFTs will be more rare and valuable and time to buy them off the market with the aim of reselling them at a higher price at a later date. While some traders may take advantage of the lack of regulation, many others may avoid certain projects for this reason and even have documented potential crimes. This is exemplified by the fact that traders themselves first exposed Chastian’s alleged criminal activity by using blockchain records to link his trades to his publicly known Ethereum address. It is possible that if scrutiny continues from either the crypto community or the government, more indictments will arise in the future.

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