Last updated: 09:27 / Thursday, 16 June 2022
The Chastain Case

NFTs are growing, but so are their controls and regulations

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  • The digital objects can vary, a large section of the market involves digital artwork and images
  • In May, the SEC announced that it had doubled the size of its crypto assets and cyber unit. Tucked into the announcement was a statement that the SEC will “focus on investigating securities law violations related to” NFTs as well as other crypto assets and stablecoins
  • The SEC believed that the facts of this case and the particular digital assets involved did not present a strong case for insider trading

U.S. Department of Justice last week took an innovative step in applying established criminal theories of liability to non-fungible tokens (NFTs), said an article by Nasdaq.

On June 1, the U.S. attorney’s office for the Southern District of New York announced an indictment charging Nathaniel Chastain with engaging in an insider trading scheme involving NFTs sold on OpenSea, an NFT marketplace, where Chastain previously worked.

The DOJ trumpets the indictment as the “first ever digital asset insider trading scheme” and follows President Joe Biden’s executive order in March calling for various federal agencies to ensure “responsible development of digital assets.”, adds the article posted on the Nasdaq website. 

Coupled with the executive order, the indictment sends a strong signal for operators of NFT and cryptocurrency marketplaces that regulators are watching.

An NFT is a type of digital asset stored on a blockchain that provides proof of ownership and a license to use it for specific purposes. Although the digital objects can vary, a large section of the market involves digital artwork and images. OpenSea permits users to create, sell and buy NFTs on its platform. Creation and transfers are evidenced on the Ethereum blockchain, and purchases are commonly made with ether, a cryptocurrency native to the Ethereum blockchain.

According to the indictment, Chastain took advantage of the way OpenSea promotes NFTs on its site. Multiple times per week, OpenSea lists “featured NFTs” on its homepage. Featured NFTs usually appreciated in price after appearing on the homepage because of the “increase in publicity and resulting demand.” The Indictment alleges that Chastain knew which NFTs OpenSea would feature on its homepage, because he sometimes, in his role as an OpenSea employee, selected them.

The Indictment further alleges that Chastain agreed to keep these selections confidential and to not use his knowledge of the selections for personal gain.

New York prosecutors' case

The Southern District of New York alleges that Chastain acted on that confidential business information before it became publicly known. According to the prosecutors, Chastain purchased NFTs shortly before they were featured on the OpenSea homepage and resold them at double, triple, quadruple or even quintuple the price he originally paid, compiles the report.

Chastain allegedly concealed the scheme by purchasing and selling the NFTs from various anonymous accounts and then transferring funds through even more anonymous accounts to cover his tracks.

While the indictment alleges facts and methods commonly seen in typical stock-related insider trading cases, it differs from common insider trading prosecutions in important ways. The indictment charges Chastain’s scheme as a violation of the general wire fraud statute, rather than as a violation of the U.S. Securities and Exchange Commission's insider trading statute and rules.

Nonetheless, the indictment uses the same insider trading theory commonly found in violations of another statute.

For instance, the wire fraud count is premised on a “violation of the duties [Chastain] owed to OpenSea.” In other words, the DOJ’s theory is that the breach of Chastain’s agreement with OpenSea not to use confidential business information for personal gain constituted wire fraud. While insider trading prosecutions require a breach of duty, wire fraud prosecutions do not.

Although the indictment is grounded in the language commonly seen in insider trading cases – e.g. “confidential business information” and “obligation to refrain from using such information”– it stops short of labeling the NFTs at issue as securities. Thus, it appears that the government was concerned that it could not prevail if it brought this case as a typical insider trading case.

If this wire fraud theory proves successful, the DOJ could theoretically use it as a model to police market manipulation for other assets, regardless of whether they are considered securities.

It is curious that there is no companion SEC case to the action by the Southern District of New York. The SEC has been focusing on regulation of digital assets, especially NFTs, states the article.

In March, Bloomberg reported that the SEC was probing NFTs and had issued subpoenas related to NFT offerings. In May, the SEC announced that it had doubled the size of its crypto assets and cyber unit. Tucked into the announcement was a statement that the SEC will “focus on investigating securities law violations related to” NFTs as well as other crypto assets and stablecoins. And SEC Commissioner Hester Peirce reiterated that the SEC was focusing on fractional NFT s and NFT baskets.

Are NFTs securities?

With all the attention and resources devoted by the SEC to examining cryptocurrency markets, it would not be surprising if the SEC took the position that some - or even many - NFTs are securities, according Nasdaq's text. That position would fit with its aggressive stance on cryptocurrency regulation, adds.

In fact, it appears that the SEC has already asserted that some NFTs are securities. That same assumption forms the basis for its recently issued subpoenas related to NFT offerings. What remains uncertain is not whether the SEC will be aggressive in regulating the NFT markets, but how aggressive it will be and, of course, whether its interpretation of the definition of securities as it relates to NFTs will be upheld by a court.

Most likely, the SEC believed that the facts of this case and the particular digital assets involved did not present a strong case for insider trading. It appears that not only the SEC, but also the Department of Justice, plan to aggressively regulate manipulative behavior in the digital asset markets.

To read the full Nasdaq article click here.

 

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