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Scams or Gems? NFTs in the Art Market

June 19, 2023

By Seoryung Blair Park

Looking at NFTs and seeing dollar signs was recently a common affliction. The COVID-19 pandemic not only accelerated online shopping and dating but also created a digital art fever involving non-fungible tokens (NFTs). Over three million pieces of NFTs were traded that have a total value of over $2 billion.[1] In 2021, this art market saw a spike in digital trading due in part to the inability for art collectors to physically purchase pieces during the pandemic.[2]

While NFTs can be digital gold mines for artists, designers, purchasers, and investors, the NFT art market can also be a malicious playground for scammers. Cybercriminals are getting bolder and more creative in ways to steal the wealth and intellectual property of unwary participants through a variety of different scams.

Moreover, the abundance of scams across a booming digital art space has created a phenomenon called FUD – fear, uncertainty, and doubt — to a level that can significantly affect traders’ NFT experiences.[3] According to the report by Elliptic, a London-based provider of crypto asset risk management services to businesses worldwide, the NFT scam wave has “the potential to reduce the accessibility or enjoyment with NFTs to both new and existing traders.”[4]

Whether one is an NFT trader or not, knowing the common scams within the NFT market can help stay safe from them. One should be beware of scammers, else risk loosing significant assets and fast.

Different Forms of Scams

The “Rug Pull” 

Fake sites are not the only NFT scams to watch out for. Some NFT projects are themselves a scam. Fraudsters promote counterfeit NFT collections, claiming that these are bound to be profitable investments in the future. They then swiftly abandon the project once the prices hit a high ceiling and transfer the funds to their various digital wallets.[5] Those who invested in the project are not given anything they were promised and “ghosted” by the developers.

This type of scam is known as rug pulls—the latest form of fraud where developers trick people into investing in a project and then steal their digital tokens. The rug pull costs investors hundreds of millions of dollars a year.[6] In 2021, this scam has gathered nearly three billion dollars, accounting for 37% of all cryptocurrency scam revenue for the year.[7]

While rug pull scams are the most unsafe and hard-to-spot type of NFT scam to the victims, the obscurity inherent in the decentralization procedure makes committing scams like these simple for criminals.[8] Given the flexibility of Web3 in creating new decentralized projects with new tokens and freedom from intermediaries for financial transactions, scammers have unrestrained opportunities to exploit unsuspecting victims with their extravagant claims.[9] And the rising interest in metaverse technologies makes them an easy promise by scam projects.

Case Study: The First “Rug Pull” Case

In March 2022, the U.S. Attorney’s Office for the S.D.N.Y. charged the two creators of the Frosties NFT collection for committing a $1.1 million rug pull.[10] Nguyen and Llacuna were charged with (1) conspiracy to commit wire fraud in violation of 18 U.S.C. §1349 and (2) conspiracy to commit money laundering in violation of 18 U.S.C. §1956(h).[11]

According to the complaint, the defendants lied to purchasers that in addition to its unique collection of 8,888 ice cream scoop characters NFTs, they would receive certain benefits, such as giveaways and access to a metaverse game.[12] Then, after having sold all 8,888 NFTs and raising funds from purchasers, they shut down the project’s website, closed the Discord server, and transferred all of the sales proceeds to their digital wallets.[13] The defendants used Tornado Cash, a cryptocurrency transaction “mixer,” that allows one to transfer crypto from one wallet to another without creating noticeable links between them.[14] Meanwhile, devastated investors rushed to sell Frosties at a substantial discount, earning only a few dollars back.[15]

The defendants were arrested right before they prepared to launch the sale of the second set of NFTs advertised as “Embers.”[16] The second project was anticipated to generate approximately $1.5 million in cryptocurrency proceeds.[17] Now, they each face 20 years in prison.[18]

This landmark case in the NFT space has drawn the attention of the authorities, so it could set the tone for future cases and regulations in the space. It demonstrated that whether to classify digital assets as securities, commodities, or a separate asset class entirely does not matter to wire fraud charges.[19] In the eyes of law enforcement, NFTs are no exception to the general rule that “you can’t solicit funds for a business opportunity, abandon that business, and abscond with money investors provided you.”[20]

Insider Trading 

Last year, the Department of Justice (DOJ) brought a charge against a former employee of the NFT marketplace, labeling it “the first-ever digital asset insider trading scheme.”[21] What is striking about this case is that the defendant’s indictment was not based on the typical insider trading statutes involving securities law violations but instead the general wire fraud statute.[22] While this case contains facts and methods usually seen in stock-related insider trading cases, it differs from traditional insider trading prosecutions in crucial ways.[23]

This strategy by the DOJ provides prosecutors with a key advantage in digital asset cases. If the government brought the case as a typical insider trading case, there is a strong likelihood that it may not prevail since many NFTs are not securities but serve as a tool that represents the buyer’s ownership of discrete assets, such as a work of art or the rights to a song.[24]

Case Study: The First Digital Asset Insider Trading Scheme

In June 2022, the S.D.N.Y. charged the former executive at OpenSea, Nathaniel Chastain, with wire fraud and money laundering.[25] Similar to the Frostie case, the defendant was charged under the wire fraud statute 18 U.S.C. §1343. The indictment followed President Joe Biden’s executive order calling for federal agencies to ensure “responsible development of digital assets.”[26]

According to the indictment, Chastain was an employee of OpenSea who took advantage of his access to confidential information before it became publicly known.[27] OpenSea would promote NFTs on its site by listing “featured NFTs” on its homepage multiple times a week, and these NFTs usually appreciated in price due to the increase in publicity and resulting demand.[28] Because Chastain sometimes selected which NFTs would feature on the homepage, he purchased those NFTs in advance and resold them at a much higher price, earning a profit of around $67,000.[29] Furthermore, just like the defendants in the rug pull case, Chastain exploited the decentralized nature of NFTs on the blockchain to cover his tracks. He purchased and sold the NFTs from various anonymous accounts and then transferred funds through even more anonymous accounts to cover his tracks.[30]

Chastain moved to dismiss the indictment based on three grounds. First, the wire fraud count should be dismissed because the “confidential business information” he allegedly misappropriated and the sale of NFTs was not OpenSea’s “property” within the meaning of the wire fraud statute.[31] Second, the DOJ could not prove that he engaged in money laundering because transactions on the Ethereum blockchain are public.[32] Third, the wire fraud argument based on a “misappropriation theory” was insufficiently pleaded because an “insider trading” charge requires trading in securities or commodities, and NFTs are neither.[33]

Nevertheless, in October 2022, the district court refused to dismiss the indictment.[34] While it conceded that Chastain’s arguments “have some force,” it concluded that his points are for a jury to decide at trial as they are “about the sufficiency of the evidence, not the adequacy of the indictment.”[35] For the court, the question of whether NFTs are securities or not was of no consequence: the DOJ did not actually charge him with insider trading as defined under securities law.[36] In contrast to section 10(b) insider trading claim which requires fraud “in connection with the purchase or sale of any security,” section 1343 provides flexibility as it is not limited to securities or commodities.[37] Therefore, the court ruled that whether the “insider trader” label was misleading was an issue to be handled separately by striking it from pleadings or precluding it at trial.[38]

According to the U.S. Attorney Damian Williams, Chastain’s charge demonstrates “the commitment of this Office to stamping out insider trading—whether it occurs on the stock market or the blockchain.”[39] Although we will have to wait and see if the DOJ’s wire fraud theory proves successful, this case presents a strong possibility that the DOJ could theoretically use it as a model to police market manipulation for other modern activities in the digital asset space—and beyond— regardless of whether they are considered securities.[40] The SEC’s jurisdiction is limited to enforcing securities laws, but the DOJ can “dodge the knotty question of whether the asset is a security.”[41]

Takeaway 

Scams are not unique to NFTs, as we see them in various areas of financial services and many other parts of life. The threat of NFT fraud, however, raises some interesting and novel legal questions.

The legal status of NFTs can be murky as there is no official law governing NFTs, but there are still ways by which individuals can be held criminally liable. Although better safety measures are certainly required to prevent NFT scams, regulators have taken an innovative step in applying established criminal theories of liability to NFTs.

While the law in this area is uncertain and rapidly evolving, it pays off for purchasers and creators to perform due diligence to avoid common scams. As with any investment, performing due diligence on the NFT project is imperative— especially when extravagant claims are made by proponents.

ABOUT THE AUTHOR

Seoryung Park is a graduate of the University of Connecticut School of Law with a concentration in IP law. She was an associate editor on the Connecticut International Journal of Law. She earned B.A. in criminology at the University of Toronto. She loves fashion, art, music, and catching her favorite TV shows. She does not own any NFTs but enjoys learning about them.

Image by Iryna Khomenko via Shutterstock: https://www.shutterstock.com/image-vector/nft-theme-design-nonfungible-token-sign-1935174506

Select Resources:

  1. Eray Arda Akartuna et al., NFTs and Financial Crime: Money Laundering, Market Manipulation, Scams & Sanctions Risks in Non-Fungible Tokens, ELLIPTIC (Aug. 24, 2022), https://www.elliptic.co/resources/nfts-financial-crime. ↑
  2. Id. ↑
  3. Akartuna, supra note 1. ↑
  4. Id. ↑
  5. Andrew Rossow, Scams Explained: What Are Rug Pulls? Are They a Crime?, NFTNOW (Apr. 14, 2022), https://nftnow.com/guides/scams-explained-what-are-rug-pulls-and-are-they-a-crime/. ↑
  6. Zack Abrams, How the FBI Made Its First NFT “Rug Pull” Bust – Just in Time to Save Other Would-Be Victims, THE BUS. OF BUS. (Mar. 28, 2022), https://www.businessofbusiness.com/articles/how-the-fbi-made-its-first-nft-rug-pull-bust-just-in-time-to-save-other-victims-from-the-same-fate/. ↑
  7. Rossow, supra note 38. ↑
  8. Felix, supra note 26. ↑
  9. James Howell, Web3 Scams and How to Avoid Them, 101 BLOCK CHAINS (Mar. 9, 2023), https://101blockchains.com/web3-scams/. ↑
  10. Ian McGinley, Wire Fraud: The Most Powerful Law in Crypto Right Now, REUTERS (Aug. 23, 2022), https://www.reuters.com/legal/legalindustry/wire-fraud-most-powerful-law-crypto-right-now-2022-08-23/. ↑
  11. Scott H. Kimpel, DOJ Brings Criminal Charges Against Two Defendants in NFT Fraud, 12 NAT’L L. REV., 89 (2022), https://www.natlawreview.com/article/doj-brings-criminal-charges-against-two-defendants-nft-fraud; See also Complaint, U.S. v. Nguyen, 22-mag-2478 (S.D.N.Y. Mar. 15, 2022). ↑
  12. Id. at ¶ 2. ↑
  13. Rossow, supra note 38. ↑
  14. Abrams, supra note 39. ↑
  15. Nguyen, ¶ 10(c). ↑
  16. TFL, https://www.thefashionlaw.com/doj-hits-creators-of-frosties-nfts-with-conspiracy-fraud-charges/ (last visited Oct. 16, 2022). ↑
  17. Id. ↑
  18. Id. ↑
  19. McGinley, supra note 43. ↑
  20. Press Release, Dept. of Justice, Two Defendants Charged In Non-Fungible Token (“NFT”) Fraud And Money Laundering Scheme (Mar. 24, 2022), https://www.justice.gov/usao-sdny/pr/two-defendants-charged-non-fungible-token-nft-fraud-and-money-laundering-scheme-0. ↑
  21. Joshua M. Newville & Jonathan Mollod, District Court Declines to Dismiss NFT “Insider Trading” Indictment against Former OpenSea Employee, PROSKAUER (Nov. 15, 2022), https://www.proskauer.com/blog/district-court-declines-to-dismiss-nft-insider-trading-indictment-against-former-opensea-employee. ↑
  22. Id. ↑
  23. David Axelrod & Andrew N. D’Aversal, How the Feds are Prosecuting NFT Insider Trading Scheme as Wire Fraud – and Why That Matters, COINDESK (Jun. 10, 2022), https://www.coindesk.com/layer2/2022/06/10/how-the-feds-are-prosecuting-nft-insider-trading-scheme-as-wire-fraud-and-why-that-matters/. ↑
  24. Chris Sloan, NFTs: Securities Law and Fraud Concerns, CROWDFUND INSIDER (Jun. 8, 2022), https://www.crowdfundinsider.com/2022/07/193609-nfts-securities-law-and-fraud-concerns/. (“On the other hand, when an NFT represent a partial interest in an asset or enterprise, or a right to receive profits from a project or business, the NFT is likely to be classified as a security.”). ↑
  25. Id. ↑
  26. Axelrod, supra note 55. ↑
  27. See Indictment, U.S. v. Nathaniel Chastain, 22-cr-305, (S.D.N.Y. May 31, 2022). ↑
  28. Id. ¶ 7. ↑
  29. Axelrod, supra note 55. ↑
  30. Id. ↑
  31. Zach Lewis & Jeremy Goldman, Case Update: NFT “Insider Trading” Case Allowed to Proceed Against Former OpenSea Employee, FRANKFURT KURNIT (Oct. 21, 2022), https://ipandmedialaw.fkks.com/post/102i0p4/case-update-nft-insider-trading-case-allowed-to-proceed-against-former-opensea. ↑
  32. Id. ↑
  33. Id. ↑
  34. Newville, supra note 53. ↑
  35. Id. ↑
  36. Lewis, supra note 63. ↑
  37. Newville, supra note 53. ↑
  38. Id. ↑
  39. Andrew Pimlott, Worldwide: Beware of NFT Fraud, MONDAQ (Feb. 16, 2023), https://www.mondaq.com/unitedstates/fin-tech/1283286/beware-of-nft-fraud. ↑
  40. Axelrod, supra note 55. ↑
  41. Matthew Bultman, Ex-OpenSea Employee’s NFT Handling Runs into DOJ’s ‘Stradivarius,’ BLOOMBERG LAW (Oct. 31, 2022), https://news.bloomberglaw.com/securities-law/ex-opensea-employees-nft-handling-runs-into-dojs-stradivarius. ↑

 

Disclaimer: This article is for educational purposes only and is not meant to provide legal advice. Readers should not construe or rely on any comment or statement in this article as legal advice. For legal advice, readers should seek a consultation with an attorney.

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