The U.S. Department of Justice last week took an innovative step in applying established criminal theories of liability to non-fungible tokens (NFTs). 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.”
Coupled with the executive order, the indictment sends a strong signal for operators of NFT and cryptocurrency marketplaces that regulators are watching.
David L. Axelrod is the practice leader of securities enforcement and corporate governance litigation at Ballard Spahr LLP.
Andrew N. D'Aversa is an associate in the litigation department at Ballard Spahr.
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.
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.
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 lavished by the SEC on examining crypto markets, it would not be surprising if the SEC adopted the position that some – or even many – NFTs are securities. That position would fit its aggressive stance on the regulation of cryptocurrency. It contains echoes of former SEC Chairman Jay Clayton’s “I believe every ICO (initial coin offering) I’ve seen is a security” statement in 2018.
In fact, it appears the SEC already has asserted that some NFTs are securities. That very assumption forms the basis for its recently issued subpoenas related to NFT offerings. What remains uncertain is not whether, but how aggressive, the SEC will be in regulating NFT marketplaces and, of course, whether its interpretation of the definition of securities as it relates to NFTs will be upheld by a court.
The Chastain indictment indicates that the Southern District of New York will be a partner with the SEC in regulating NFT marketplaces.
Operators of NFT and cryptocurrency markets should require employees, to the extent they do not already do so, to keep material, nonpublic information confidential and refrain from using it for personal gain. Operators should also monitor employee behavior to ensure they are not engaging in insider trading or other manipulative behavior based on material, nonpublic information learned through their employment.
Clear policies and procedures and regular training are also important tools to stop this type of behavior. The absence of an SEC companion case here does not indicate that NFTs are safe from future enforcement by the SEC on insider trading or other grounds.
It is more likely that the SEC believed the facts of this case and the particular digital assets involved did not present a strong claim for insider trading. It appears that not only the SEC, but also the DOJ, plan to aggressively regulate manipulative behavior in digital asset markets.
Although the Commodity Futures Trading Commission rarely invokes the power, it could also theoretically invoke its insider trading statute and regulations to police futures and derivatives of digital assets. This innovative new action by the Southern District of New York indicates that federal regulators are no longer limiting their focus to digital asset securities. When it comes to market manipulation, federal regulators are watching.
