NFT Insider Trading – Can There Be A Crime If It’s Not A Security?

We have previously addressed the recent indictment against Nathaniel Chastain, a former executive of a major NFT marketplace, for insider trading involving NFTs. The indictment charges Chastain with one count of wire fraud and one count of money laundering. It does not allege that the NFT is a security. It does not allege violation of the insider trading laws under securities law. Since then, as we have reported, that SEC has been investigating lack of insider trading policies for NFT/crypto exchanges.

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NFT Insider Trading Compliance Policies – What They Cover and Why You Need One

It is well known that insider trading—the practice of buying and selling stocks, bonds, or other securities based on material, non-public information—is unlawful. For that reason, many companies have compliance programs and policies that restrict trading by officers, directors, employees or other “insiders” with access to such information. 

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DAO Liability and the bZx Class Action

A class action lawsuit filed by users of a decentralized finance (“DeFi”) protocol managed by a decentralized autonomous organization, or “DAO,” may shed light on the potential legal liabilities of a DAO and its participants. The complaint in Sarcuni v. bZx DAO, No. 22-cv-0618 (S.D. Cal. May 2, 2022), highlights several issues related to DAO liability of which DAO participants should be aware. There is a common misperception that an unincorporated DAO is not subject to liability because there is no entity for regulators to pursue. The fact is that such DAOs may be deemed general partnerships and the participants may each bear some liability for activities of the DAO. In some cases, a DAO includes a wrapper entity, in part, to shield participants from such liability. This issue highlights a tension between the aspirations of Web3 entities to be decentralized and community-governed on the one hand, and the challenges of accomplishing those aspirations given the current state of corporate law on the other hand.

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The Legit Ledger Launches: New Podcast Provides Insights and Practical Tips on Blockchain-Related Legal Issues

Sheppard Mullin is pleased to announce the launch of The Legit Ledger, a new podcast hosted by Sheppard Mullin’s Blockchain and Fintech industry team members (including partners Jim Gatto, Yasamin Parsafar, and associate Gabe Khoury) that focuses on blockchain-related legal issues and practical tips for keeping things legit. Various episodes of The Legit Ledger will feature interviews with a thought leader from the blockchain industry, including CEOs, leading attorneys, financial advisors, and technology professionals who have hands-on experience with this complex and evolving area of the law.

“The Legit Ledger is an innovative combination of legal analysis and practical advice from blockchain industry professionals on how to keep new technology solutions and business models legit,” said Blockchain and Fintech industry team leader Jim Gatto. “We will cover a range of topics related to blockchain technology and its many uses, including the metaverse, NFTs, cryptocurrency, DAOs and other Web3 legal issues. ”

The Legit Ledger, available at www.thelegitledger.com and on Apple Podcasts, Stitcher Radio, Spotify, Google Podcasts, and other leading podcast platforms, launched with three episodes:

  • Episode 1Intellectual Property Consideration for Licensing NFTs with Jim Gatto and Yasamin Parsafar. In this inaugural episode, Jim Gatto and Yasamin Parsafar address the various intellectual property considerations for licensing digital assets related to NFTs, including the specific rights that may be granted and structuring the licensing agreement to clearly and accurately reflect the rights being granted.
  • Episode 2The Current State of NFT Regulation with Jim Gatto and Gabe Khoury. In the second episode, Jim Gatto and Gabe Khoury discuss various regulatory considerations of which NFT market participants should be aware, including guidance and enforcement actions issued by the SEC, FinCEN, OFAC, plus gambling law implications, and more.
  • Episode 3Licensing Considerations for NFT Creators and Owners with Jim Gatto and Gabe Khoury. In the third episode, Jim Gatto and Gabe Khoury revisit NFT Licenses by discussing practical considerations for NFT issuers when considering commercial vs. non-commercial licenses and how NFT owners can leverage their rights.

In upcoming issues, we plan to cover: Cryptocurrency sanctions, Blockchain games, Blockchain and Real Estate, Music NFTs, and more.

We encourage you to SUBSCRIBE to the show via Apple Podcasts, Google Podcasts, Amazon Music, Stitcher Radio or Spotify to receive new episodes delivered straight to your podcast player. The Legit Ledger can also be accessed through the firm’s website at www.thelegitledger.com

May 2022 Crypto Enforcement Actions and Regulatory Guidance Roundup

In May, we saw a slower month for crypto enforcement actions by state and federal regulators. See our March 2022 Crypto Enforcement Actions Roundup blog here where we discuss the regulatory guidance and jurisdiction of federal and state agencies to enforce these matters.

Federal and State Updates

Securities and Enforcement Commission (SEC)

On May 3, the SEC announced “the allocation of 20 additional positions to the unit responsible for protecting investors in crypto markets and from cyber-related threats.” Accordingly, the Crypto Assets and Cyber Unit in the Division of Enforcement will be expanded to “50 dedicated positions.”The Crypto Assets and Cyber Unit has brought enforcement actions regarding securities law violations and for failure to maintain “adequate cybersecurity controls”—including negligent practices in disclosing cyber-related risks and incidents. The expansion demonstrates the SEC’s intent to ramp up enforcement efforts, which we will watch closely.

Department of Treasury

On May 10, Treasury Secretary Janet Yellen presented the Financial Stability Oversight Council (FSOC) Annual Report before the Senate Banking Committee about the need for sensible stablecoin legislation (we have previously discussed the President’s Working Group (PWG) report on stablecoins here and here). Secretary Yellen cites the findings in the PWG report as reason to conclude that “the current statutory and regulatory frameworks don’t provide consistent and comprehensive standards for the risks of stablecoins as a new type of payment products and urges Congress to enact legislation to ensure that stablecoins and such arrangements have a federal prudential framework.”

Commodity Futures Trading Commission (CFTC)

On May 19, the CFTC charged several individuals for fraudulently soliciting at least $44 million for participation interests in a so-called “income fund” investing in digital assets and other instruments. The enforcement action also charges the defendants with operating an illegal commodity pool and failing to register as a Commodity Pool Operator. The complaint alleges that since at least January 2021, the defendants solicited more than $44 million from at least 170 participants to purchase, hold and trade digital assets, commodities, derivatives, swaps, and commodity futures contracts. The complaint also alleges that instead of investing the pooled participant funds as advertised, the defendants misappropriated participant funds by distributing them to other participants, transferring some participant funds to other accounts under their control and for their benefit, and transferring funds to a foreign cryptocurrency exchange. None of these funds were returned to the pool.

On May 19, Rostin Behnam, Chairman of the CFTC publicly remarked that the CFTC will add resources and increase its efforts to address cryptocurrency-related fraud and manipulation cases. He stated, “[h]eadlines about the loss of tens of millions of dollars in digital assets due to protocol exploits, phishing attacks, preying on vulnerable people and other fraudulent and manipulative schemes have become far too common.” This statement is a clear signal of what actions the CFTC will likely pursue.

Financial Crimes Enforcement Network (FinCEN)

On May 19, Alessio Evangelista, the Associate Director of the Enforcement and Compliance Division of FinCEN, presented at the Chainalaysis Links Conference on the topic of “Intersection of Cryptocurrencies and National Security.” Evangelista stated that crypto firms “have the same obligations as all other financial institutions to ensure that their new offerings can leverage innovations while still protecting consumers, reducing cybercrime, combating illicit financial activity, and ensuring their platforms are not used to harm our national security.” He also stressed that the agency believes that innovation goes hand in hand with regulation, rather than being at odds with each other.

Evangelista also stated that virtual asset service providers (VASPs) ignore red flags and continue to do business with problematic companies far too often. He called on these VASPs to be proactive with regulatory compliance and to avoid having “paper programs” or compliance regimes that exist on paper but are not implemented, either by mistake or design. Here, FinCEN will continue to prioritize cases where it identifies “significant non-compliance and threats” to the financial system and where it finds “willful disregard for regulatory requirements.”

Office of the Comptroller of the Currency

On May 24, the acting Comptroller of the Currency, Michael Hsu remarked at the DC Blockchain Summit 2022 on the “deep” vulnerabilities of cryptocurrency in light of the recent market volatility and other events in the crypto economy. Hsu emphasized the vulnerabilities arising from new blockchains spinning up operations. Particularly, the crypto ecosystem has become increasingly fragmented, which presents interoperability issues. Cross-chain bridges, although providing a solution to these issues, are highly prone to being hacked.

Hsu also emphasized that the interconnectedness of the crypto ecosystem presents real contagion risks, as evidenced by the recent collapse of a popular algorithmic stablecoin, which caused other stablecoins to drop in value. Moreover, Hsu cited the lack of clear standards for the ownership and custody of digital assets as placing consumers at risk. Hsu believes these standards are underdeveloped given the size, scope, and ambitions of the industry. For example, the largest U.S. centralized exchange recently disclosed that its users would be at risk of becoming unsecured creditors if the exchange were to file for bankruptcy.

Hsu also observed that despite the volatility and loss of market capitalization after the recent stablecoin collapse, there has been no stress on traditional banking and finance due to crypto exposure, a result which he attributes, at least in part, to federal bank compliance and intentional emphasis on safety, soundness, and consumer protection. Hsu found this to be a result of the OCC’s “careful and cautious” approach to banks seeking to join the crypto economy, referenced in Interpretive Letter 1179 issued last year (we previously discussed this letter in a blog post here).

California State

Under a recent Executive Order signed by Governor Gavin Newsom on May 4th, California is urging all state agencies to work with the federal government in creating regulations for digital assets. The executive order explains the importance of this action in recognition of the fact that “California is the global innovation hub for emerging technologies because of the State’s unparalleled concentration of research and development, human and venture capital, and creativity and entrepreneurialism.”

Under the executive order, the state has seven priorities: (1) to create a transparent and consistent business environment for companies operating in blockchain; (2) to work concurrently and cooperatively with President Biden’s strategy and efforts to identify responsible regulation; (3) to collect feedback from a broad range of stakeholders for potential blockchain applications and ventures; (4) to engage in a public process and exercise statutory authority to develop a comprehensive regulatory approach to crypto; (5) to engage in and encourage regulatory clarity via progress on the processes outlined in the federal executive order; (6) to explore opportunities to deploy blockchain technologies to address public-serving and emerging needs; and (7), to identify opportunities to create a research and workforce environment to power innovation in blockchain technology.

Enforcement Actions

The Justice Department

On May 13, the Justice Department initiated its first criminal prosecution involving the alleged use of cryptocurrency to evade economic sanctions. Magistrate Judge Zia M. Faruqui explained in a 9-page decision that “cryptocurrency’s reputation for providing anonymity to users” is a “myth,” asserting that virtual currencies such as bitcoin, Ethereum or Tether are subject to the U.S. sanctions laws even though they are outside of the traditional financial system. Judge Faruqui explained that “OFAC’s recent guidance confirmed that ‘sanctions compliance obligations apply equally to transactions involving virtual currencies and those involving traditional fiat currencies.” The complaint continued, “the Department of Justice can and will criminally prosecute individuals and entities for failure to comply with OFAC’s regulations, including as to virtual currency.”

Conclusion

The crypto-regulatory and enforcement landscape remains a convoluted patchwork. There are many legal considerations involving NFTs, crypto, and other Web3 technologies. What is not murky, however, is the clear stance by U.S. regulators that, notwithstanding the novelty of the technology and asset class, basic principles still apply: registered or not, developers, protocols, projects and platforms can’t defraud retail investors; they can’t aid and abet money laundering; and they can’t violate sanctions. Stay tuned for next month’s installment of the crypto roundup.

Previous Installments

Mythical Games Scores NFL License for Blockchain Video Game

The National Football League has announced a partnership with Mythical Games to create a blockchain video game called NFL Rivals. The game will use unique, generative 3D NFL franchise-themed NFTs and let players act as a general manager to assemble a team and compete against other teams.

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The Crypto Enthusiast and The Regulator: What OFAC is, Could Be, and Should Be Doing to Regulate CryptoCurrencies

On May 6, the US Department of the Treasury’s Office of Foreign Assets Control (OFAC) designated a cryptocurrency mixer, Blender.io, as a Specially Designated National (SDN). That sanction follows a series of enforcements and sanctions which we have previously discussed here and here.

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Former NFT Marketplace Employee Charged with Insider Trading

The United States Attorney for the Southern District of New York and the Assistant Director-in-Charge of the New York Field Office of the Federal Bureau of Investigation (“FBI”), announced today the unsealing of an Indictment charging Nathaniel Chastain with wire fraud and money laundering in connection with a scheme to commit insider trading in Non-Fungible Tokens, or “NFTs,” by using confidential information about what NFTs were going to be featured on [the marketplace] homepage for his personal financial gain.  Chastain was arrested this morning in New York.  

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Securities and Exchange Commission V. LBRY; Is Your Crypto Project Illegal?

While the crypto community is rightfully focused on the Ripple case to see how the SEC will fare in court on enforcements alleging cryptocurrency offerings are a security, a lesser-known case may provide clarity first. The SEC’s suit against LBRY is scheduled for trial in September 2022.

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