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Rise Of Financial Crime In The NFT Market Elicits New Scrutiny From Regulators – Fin Tech


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

In one of these cases, the defendant, Le Anh Tuan, a 26 year-old
Vietnamese national, 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. (U.S. v. Tuan, No. 22-cr-273 (C.D.
Cal. Indictment June 28, 2022)). Seeking to capitalize on the
popular Bored Ape Yacht Club, the defendant launched the Baller Ape
Club, featuring “Baller Ape” NFTs featuring figures in
various attires decorated with colorful accoutrements. According to
the indictment, Tuan and unnamed co-conspirators first gained
access to investors’ digital wallets and processed token
transactions and then “rug-pulled” investors shortly
after Baller Ape Club’s public sales began by terminating the
purported project without notice and closing its website. In all,
approximately $2.6 million was alleged to be stolen. To hide the
stolen funds, the defendant purportedly laundered the money through
“chain-hopping,” a money-laundering scheme where funds
are moved across multiple cryptocurrency blockchains and
decentralized cryptocurrency swap services are used to obscure the
trail of the stolen funds.

U.S. v. Tuan is only the most recent 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 ever digital
asset NFT “insider trading” scheme. (U.S. v. Chastain, No. 22-cr-305
(S.D.N.Y. Sealed Indictment May 31, 2022)). OpenSea is the largest
online marketplace for the purchase and sale of NFTs. Chastain
allegedly launched a scheme by abusing his knowledge of
confidential information to secretly purchase dozens of NFTs in
advance of them being prominently featured on OpenSea. As part of
the management team, Chastain was responsible for selecting NFTs to
be featured on OpenSea’s homepage; OpenSea kept these special
NFT selections confidential until they went live, as a main page
listing often translated to a jump in prices. After the NFTs were
featured, Chastain would purportedly then sell them at profits of
two-to-five times his initial 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 large
figure given that news outlets reported at that time in August 2021
OpenSea had a sales volume of $4 billion). To
conceal the fraud, he allegedly conducted these transactions using
anonymous digital cryptocurrency wallets and OpenSea accounts. The
DOJ fashioned the charges against Chastain as one count of wire
fraud and one count of money laundering, seeking forfeiture of any
criminal proceeds, among other relief.1

These recent offenses related to NFTs bring up numerous legal
questions concerning the status of NFTs. Chief among these concerns
is the legal uncertainty as to 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 of charges associated with securities
transactions. NFTs, however, are often considered to be digital
collectibles and investment-quality digital artworks as opposed to
securities, and to date, there has been a notable lack of legal
precedent around digital assets in general that might offer 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 label of “insider trading,” the Chastain indictment
by the DOJ was not actually based on securities laws or insider
trading regulations, and is in fact based on fraud claims as
opposed to securities law violations. Considering the way the
charges were drafted in the Chastain case – the word
“security” does not appear in the indictment – the
indictment falls more under the general category of alleged
financial crimes than a securities law violation. Indeed, as U.S.
Attorney for the Southern District of New York Damian Williams noted, “NFTs might be new, but this type
of criminal scheme is not.” With new technological platforms
and investment opportunities available, money laundering and
deceptive trading practices are both age-old problems that
invariably will occur in the modern day context.

In the absence of clear guidance of the regulatory status of
NFTs, a bipartisan group in Congress has attempted to provide
clarity through the recently proposed Responsible Financial Innovation Act
(RFIA)
, sweeping bipartisan legislation which seeks to create a
complete regulatory framework for governing digital assets. The
RFIA seeks to clarify the respective jurisdictions of the
Securities and Exchange Commission (SEC) and Commodity Futures
Trading Commission (CFTC) over digital assets. If passed, the bill
would offer 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 commodities subject to oversight from
the CFTC. As a report on the bill to Congress noted: “The
RFIA would narrow the SEC’s jurisdiction over digital assets as
the agency currently conceives it.”

Despite the potential passage of the RFIA, it is important to
note that the SEC has previously stated that NFTs can still
be considered securities if they pass the ‘Howey
Test,’
which stipulates that an “investment
contract” exists when there is the investment of money in a
common enterprise with a reasonable expectation of profits to be
derived from the efforts of others. SEC v. W.J. Howey Co.,
328 U.S. 293 (1946). The SEC generally looks to the
Howey Test’ along with the nature of the
transaction rather than the good being sold in order to determine
whether an investment contract exists. Thus, even if certain
digital assets were treated as commodities under a new legal regime
that features an expanded CFTC role, the SEC would presumably still
seek to regulate digital assets that it believes are being used to
raise money in the manner of a traditional security or are bundled
and fractionalized 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 assets law. Though, as Chair Gensler commented recently about the RFIA
bill
, he is concerned that deregulating certain digital assets
or removing them from the SEC’s jurisdiction might create
loopholes or “undermine” the overall regulation of the
markets.

As revealed by the OpenSea and “Baller Ape” NFT
indictments, blockchain’s decentralized nature and the
transparent ledger can at times facilitate criminal activity and
also expose it. Taking advantage of these innate qualities of
blockchain technology while increasing responsible regulation from
the SEC or the CFTC may help promote a more robust, but safer
crypto space. At the same time, however, the increased regulation
may also counter the spirit of the crypto world, where many
investors have turned precisely due to the lack of regulation in
hopes of making their fortunes.

Footnote

1. Within the uncertain legal climate regarding digital
asset regulation, several news sources have pointed out that this
type of conduct may be much more common than expected. Some
traders, unlike Chastain, may simply be more careful and better at
hiding their traces. One NFT trader and creator, Fedor Linnik,
confided that insider trading can happen in popular projects
with 10,000 profile picture-style NFTs
. Initial buyers of a
newly minted NFT collection cannot discern the traits or valuable
rarities unique to their own NFT until the reveal, allowing a gap
in time for creators who know which unrevealed NFTs will be more
rare and valuable and time to furtively buy them off the market
with the goal of reselling them at a higher price at a later time.
While certain traders may be capitalizing on the lack of
regulation, many others might avoid certain projects for this
reason and have even documented potential crimes. This is
exemplified by the fact that traders themselves first exposed Chastian’s alleged criminal
activity
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.

Rise Of Financial Crime In The NFT Market Elicits
New Scrutiny From Regulators

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.



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