The Rise of Fraudulent Insolvencies of NFT Projects: What to Do When You’re Stuck?

NFTs are non-fungible tokens that can be held and transferred on blockchains. Alongside the growth of NFTs as a digital asset class has also come the rise of default-based insolvencies of NFT projects. “Rug pulls” are crypto scams perpetuated against investors in NFT projects, where creators offer a collection of NFTs for sale, but ultimately make off with investors’ digital tokens and/or funds.¹ As reported by Chainalysis, in 2021, over USD 2.5 billion worth of cryptocurrency assets were stolen or defrauded from victims worldwide via blanket fraud.²

Although there are different types of carpet covers, one of the most common is a “pump and dump” arrangement. Generally speaking, scammers can create an altcoin or target a small-cap token that is then amplified over social media; once the relevant coin or token is purchased, the tokens/coins are then dumped on the market – often leaving investors with bags of worthless products. While the Department of Justice publicly announced enforcement actions charging individuals with crypto-fraud offenses in the United States in 2022,³ it remains unclear whether Canadian police are actively pursuing the perpetrators of carpet pulling interjurisdictively.

This article aims to summarize recent North American jurisprudence and news regarding recent rug pulls and concludes with steps creditors or investors can take to recover their money if they have experienced fraud or misconduct due to a rug pull.

North American jurisprudence

(a) Classification

Most North American litigation involving NFT projects still originates in the United States, and a significant amount of NFT lawsuits still revolve around classification issues of the digital assets themselves. As an example, a May 2021 class action lawsuit was filed by investors who had purchased Moments NFTs (“Moment“).⁴ In the lawsuit in the Southern District of New York, the plaintiffs alleged that a Vancouver-based Web3 company, Dapper Labs, violated federal US securities laws by failing to register Moments with the US Securities and Exchange Commission before the sale. Dapper Labs responded by filing a motion to dismiss on the grounds that Moments — which capture NBA highlights — are not securities, but rather tradable commodities along the lines of digital basketball cards.

Judge Victor Marrero held that the plaintiffs sufficiently alleged that Moments constitute investment contracts under the four-step test first articulated in SEC v. WJ Howey Co.,⁵ indicating that a given transaction comprises an investment contract if it involves: (a) an investment of money; (b) a joint venture; and (c) a reasonable expectation of profit that (d) derives from the efforts of others. As a result, the pending complaint was allowed to proceed and the motion to dismiss by Dapper Labs was denied, although Dapper Labs has since released a public statement on Twitter that Moments “are just modernized trading cards, not financial instruments”⁶ and that they “look forward to defending our position in court as the case continues”.⁷

The eventual holding of the ongoing Dapper Labs case is likely to trigger regulatory scrutiny against centralized companies in the NFT space. Crypto commentators have indicated that while regulators may continue to apply the Howey Test taps to projects that pose a risk of being classified as securities, the final ruling will be a significant step in providing regulatory clarity for all NFT projects, whether public or private.⁸

(b) Carpet covers

An increasing number of defrauded investors have initiated civil lawsuits for losses in the United States in 2023, although the growth of jurisprudence in Canada remains limited. US consumer groups have further put some high-profile celebrities, including Gwyneth Paltrow, Tom Brady and others, on public watch for “promoting NFTs without appropriate disclosures”.⁹

Two key cases from 2023 in the US and Canada that are likely to shape the scope of future carpet litigation are highlighted below.

United States

Influencer Logan Paul is currently facing a rugpull class action lawsuit over his involvement in CryptoZoo NFTs, which were originally announced and marketed starting in September 2021. The class action was filed in the District Court of the Western District of Texas in Holland v. CryptoZoo Inc. et al.,¹⁰ claims that while CryptoZoo was marketed as an NFT-based game and billed as “an autonomous ecosystem” that would enable virtual “ZooKeepers” to buy, sell and trade exotic animals on a blockchain, in reality:¹¹

This action seeks recovery from the defendants for their false marketing and sales of products that did not work as advertised, failed to support the CryptoZoo project, and manipulated the digital currency. Defendant operated this fraudulent venture to exploit and steal from Plaintiff and other customers who relied on Mr. Paul’s false representations. As a result, Defendants defrauded Plaintiff and thousands of other consumers, and unjustly enriched themselves by profiting from Plaintiff and others without keeping their promises.

While Paul had previously tweeted that he intended to create a $1.3 million reward program for “disappointed players”¹² the February 2023 class action filing by investors alleges that “Logan Paul and the defendants knew or should have known that they were falsely advertising a non-functional product and that consumers would be deceived by their false representations.”^{1. 3} A ruling on CryptoZoo, if not settled out of court, is likely to symbolize a significant move forward in the growth of crypto-lawsuits around carpetbaggers.

Canada

In December 2021, a Quebec plaintiff sought both injunctive and mandatory temporary injunctions seeking to be recognized as the owner of 25 percent of the shares of a partnership in an NFT project in order to gain access to all relevant business information and benefit from the profits generated from there.¹⁴ This relief was refused.

In a disappointing comment from the Quebec court, it was determined that since cryptocurrency wallets are virtual and “not controlled or located in any particular jurisdiction, which would make such an order impossible to execute.”¹⁵ The court itself could not order that the defendants “retain control of cryptocurrency wallets in the province of Quebec.”¹⁶ Courts should be well aware that this remark continues a long line of comments by North American courts, where decisions are made by the judiciary itself, that they are not confident that even courts have personal jurisdiction over defendants due to the virtual nature of the digital . wallets in question.¹⁷ Claimants should be well reminded that legal practitioners must advise the courts of the characteristics of the relevant NFTs to demonstrate their link to the relevant jurisdiction, as otherwise procedural challenges due to mis-education may impede their ability to seek judicial relief and redress .

Conclusion and next steps

There are certain warning signs that investors should be aware of when placing funds in cryptoassets or cryptoasset projects such as NFTs or tokens: (a) poor fundraising goals or endpoints; (b) limited background information on founders; and (c) purchased followers or fabricated websites, along with disproportionate profits. Despite these signs, it is very easy for investors to accidentally fall victim to fraud.

If you have been defrauded in a carpet cover, the following steps can be taken:

1. Legal contact by a lawyer should be made with stablecoin or exchange providers to freeze hacks or stolen funds, rather than immediately jumping to civil litigation. In light of the slow recovery rate and limited jurisprudence involving rye moves, efforts should first be made to reach out to crypto-asset providers rather than the legal system to recover default-based insolvency NFT funds. Often, cryptoasset providers and/or exchanges are able to freeze funds through processes external to traditional North American legal recovery systems.
2. If legal action is initiated through the Canadian legal system, claimants should consider using traditional insolvency tools such as the appointment of receivers, if available, rather than simple civil recovery methods. There have been successful cases of returning coins to estates following outstanding claims for unjust enrichment, conversion and fraudulent transfer. As an example, in the American case Rasmussen,¹⁸ a court-appointed receiver sued the defendant to recover funds derived from a cryptocurrency payment made by an entity, AriseBank, for the purchase of a non-existent bank.
3. If insolvency litigation tools are unavailable, litigants should turn to alternatives such as injunctions, as well as consider the involvement of litigation funders. Furthermore, when seeking assistance from a Canadian or US court to recover funds through a civil process, steps should initially be taken to track missing or stolen crypto assets using independent crypto tracking firms. It is likely that courts will require reports from litigants to prove the movement of funds, particularly if mixers or tumblers are involved, and given the jurisdictional issues discussed above.