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First DOJ NFT Insider Trading Charges Mark New Enforcement Era

June 29, 2022, 8:00 AM

The Department of Justice is ramping up enforcement efforts with respect to the non-fungible token (NFT) marketplace, and recently brought the first indictment ever against a person for an alleged digital asset insider trading scheme.

Even with this increased enforcement, the DOJ will need to rely on the NFT community and recognized market experts to keep up with the developing sector.

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

The government alleges Chastain, who was responsible for selecting NFTs to be featured on OpenSea’s website, purchased the NFTs before they were put up for bid. He is charged with wire fraud and money laundering.

The money laundering charge alleges that Chastain used anonymous accounts on the marketplace to conceal his identity and transferred the NFTs via hot wallets (cryptocurrency wallets that are always connected to the internet) to avoid getting caught. Chastain’s alleged activity was first detected by the NFT community who were able to trace the transfer of NFTs and funds back to his public account.

Meanwhile, the wire fraud charge has garnered interest because absent from the allegations is the word “securities.” The case could provide clarity in the NFT sector as to what transactions involving NFTs should be categorized as securities under the Howey Test, which is used to determine when a transaction is subject to US securities laws.

The DOJ alleges Chastain invested money in NFT projects expecting to sell the NFTs for a profit. The allegations, if proven true, could broaden the class of NFTs considered as securities—a far departure from the popular misconception of NFTs as merely digital images.

Evolution of NFTs

In the past few years, NFTs have evolved from primarily collectible digital images to blockchain representations of ownership rights. NFTs are now more commonly used as a fractional interest of a marketplace that may or may not be tied to a collection of physical or digital things. The value of these NFTs is often determined by the liquidity of the markets and the promotional savvy of project and marketplace managers—third parties—rather than as a simple asset.

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 capabilities 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 policies 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 tasked with policing insider trading are in a better position to investigate individuals who use their respective positions for profits given their expertise and resources. As noted above, however, the NFT community is an invaluable resource for both companies and investigators.

Current State of Enforcement

The DOJ is well aware of the potential for fraud in the NFT space and has already exercised its enforcement power over the NFT industry. Two months ago, the DOJ indicted two individuals for conspiracy to commit wire fraud and conspiracy to commit money laundering arising out of an NFT project. The organizers allegedly misappropriated the funds received by wallets under their control and abandoned the project before providing the advertised incentives. The same individuals reportedly planned to launch a second NFT project with the same intent, but the DOJ indictment stopped them before the second project’s release.

To meet the rapid expansion of cryptocurrencies and NFTs, the DOJ established the National Cryptocurrency Enforcement Team (NCET) in February. Eun Young Choi, a seasoned prosecutor with nearly a decade of experience, was named its first director. Choi was instrumental in the prosecution of Silk Road founder Ross Ulbricht, which resulted in his life sentence. The Silk Road was a dark-web marketplace in existence from 2011 to 2013 that enabled users to purchase illegal items such as drugs, guns, and even exotic animals anonymously through payments of bitcoin.

In addition to Choi’s expertise and leadership, the NCET has openly advertised that it will rely on the private sector to assist in its oversight of the NFT industry. Notably, there already exist countless social media accounts that are dedicated to the vetting of NFT projects and tracking suspicious activity. Many of these industry experts (and perhaps some self-proclaimed experts) have hundreds of thousands of followers, allowing for the widespread dissemination of information. By working with these authors and resource aggregators, the DOJ hopes to provide oversight for a larger portion of the market.

An overwhelming majority of the NFT community believes that government oversight is needed. Thousands of scams occur every day with little recourse for those whose digital assets are stolen. Information disparities remain rampant. The DOJ and other government agencies recently increased their efforts through the formation of units focused on cryptocurrencies, but these efforts need to be extended.

Just as with this first NFT indictment for insider trading, the DOJ will need to rely, at least in part, on the NFT community to alert them of suspicious activity to ensure justice as the utility of NFTs grows.

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

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Author Information

John Cahill is an associate in Wilson Elser’s White Plains, N.Y., office. His practice focuses on cryptocurrencies, NFTs in particular, and he researches current trends to ensure that clients are in compliance with any current and developing legal restrictions.

Jana S. Farmer is a partner in Wilson Elser’s New York Metro offices. She chairs the firm’s Art Law practice, and is a member of the firm’s Intellectual Property and Technology Practice. She focuses on the development, acquisition, licensing, and exploitation of intellectual property, including in transactions involving NFTs.

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