Doj Charges Wire Fraud (read: Insider Trading) in Nfts

• Publication year: 2022

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Kit Addleman, Vicki L. Odette, Shelley J. Rosensweig, and Stuart Slayton ^*

The authors explain that those in the non-fungible tokens and crypto industry more broadly should be aware that just because a particular digital asset may not technically be a security, conduct surrounding the crypto industry has been, and always will be, subject to the full panoply of federal law.

In a recently unsealed indictment, the U.S. Department of Justice ("DOJ") charged Nathaniel Chastain with wire fraud and money laundering ¹ in a scheme that has been billed as "insider trading." ² Chastain was previously a product manager tasked with selecting non-fungible tokens ("NFTs") to be displayed on the homepage of OpenSea, one of the largest and most popular NFT marketplaces. ³ At the time of this alleged scheme, Open-Sea had a confidentiality policy in place that prohibited using OpenSea's confidential business information except to perform work for OpenSea; Chastain signed an agreement acknowledging this duty of confidence when he joined OpenSea.

The DOJ alleges that from approximately June 2021 to September 2021, Chastain "misappropriated OpenSea's confidential business information" regarding which NFTs would be featured on its homepage. ⁴ According to the indictment, Chastain used this confidential information to purchase dozens of NFTs prior to their homepage debuts and subsequently sold them after they were featured, resulting in a return to Chastain anywhere between two to five times his purchase price. ⁵ To conceal the operation, the DOJ contends that Chastain used anonymous Ethereum wallets and OpenSea accounts rather than those publicly held in his name. ⁶ Nonetheless, a Twitter user uncovered Chastain's ownership of some of the Ethereum wallets buying NFTs before they landed on OpenSea's homepage. This discovery led OpenSea to request Chastain's resignation, and, ultimately, to his indictment. ⁷

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What Is an NFT?

An NFT is a digital asset that exists and lives on a blockchain, which, broadly described, is a digital, decentralized ledger that stores information and whose accuracy is verified by the combined computing power of its users rather than a single intermediary. ⁸ NFTs are often associated with a digital object that provides proof of the digital object's ownership and a license to use the object for all or some purposes. NFTs have recently gained prominence as an avenue for buying and selling digital artwork, among other uses, and some NFTs sell for millions of dollars. ⁹

An NFT's ownership and rights are automatically verified and enforced by the NFT's code on the blockchain. ¹⁰ The Ethereum blockchain is the most popular chain for creating—or "minting"—NFTs, in part because the Ethereum blockchain enables "smart contracts." Generally, a smart contract is a computer program that automatically executes certain actions according to predetermined terms. For example, a smart contract could allow an NFT creator to retain his rights to revenue or royalties with respect to future sales or uses of an NFT.

What Is "Insider Trading"?

While Chastain's alleged wrongdoing is rightly called "insider trading," Chastain was not charged as most insider-trading defendants are. As is typically prosecuted, insider trading is prohibited under the Securities Exchange Act of 1934 (the "Exchange Act") as a "device, scheme or artifice to defraud . . . in connection with the purchase or sale of any security." ¹¹

Insider trading is more a colloquial term referenced in court decisions, and it is not specifically defined or prohibited by any federal law, despite several Congressional proposals to do so. ¹² Instead, insider trading is "by historical accident, a creature of the securities laws." ¹³

Under the Exchange Act, there are several theories of insider trading, and Chastain is accused of conduct most resembling the "misappropriation theory." Under this theory, if a person possesses "material nonpublic information" ("MNPI") and owes the source of the MNPI a duty of trust and confidence, then the person is generally prohibited from using that MNPI to trade securities for personal gain. ¹⁴ If a person exploits MNPI in this way, the

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misappropriation theory holds that the person has "defrauded" the source under the Exchange Act. ¹⁵

Chastain's "Insider Trading" of Certain NFTs

In what appears to be a classic example of the misappropriation theory in action, Chastain is accused of embezzling OpenSea's confidential business information regarding which NFTs would be featured on its homepage, one of Chastain's job responsibilities. With the benefit of the pilfered particulars, Chastain timed his trades of those NFTs for his personal gain, thereby breaching his agreement to use that information only for OpenSea's benefit. But in spite of the similarities to the misappropriation theory, the DOJ did not charge Chastain with defrauding OpenSea under the Exchange Act, leaving one to question the non-inclusion. ¹⁶ The explanation resides in the Exchange Act's requirement that the fraudulent scheme be connected to the transaction of "any security."

The SEC's Digital Asset Guidance and "Any Security"

In the Exchange Act, Congress was notoriously long-winded in defining what a security is, ¹⁷ and the Supreme Court has said that whether something is a security depends not only on the form and terms of the instrument but also on the circumstances surrounding it. ¹⁸ Determining whether some thing is a security is a factually intensive question, thus it was not immediately clear whether the digital assets that began springing up over a decade ago were securities. In response, the Securities and Exchange Commission ("SEC") published guidance on how to determine whether a particular digital asset, like an NFT, is a security under federal law. ¹⁹

In that guidance, the SEC applies the Howey ²⁰ test to determine whether a digital asset is an "investment contract," a type of security under the Exchange Act. ²¹ Under Howey, an "investment contract," and hence a security, exists when there is:

• An investment of money;
• In a common enterprise;
• With a reasonable expectation of profits to be derived from the efforts of others.

Under this test, the SEC has stated that some digital assets, like Bitcoin or Ethereum, are not securities, while other digital assets,

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like many coins in initial coin offerings, satisfy Howey's tripartite test. ²²

According to the Howey test and the SEC's guidance, some NFTs may be considered an "investment contract," and hence a "security" under federal law. In Chastain's indictment, the DOJ entirely avoided the question of whether the NFTs Chastain traded are in fact securities under the Exchange Act. Rather than charging Chastain with violating the Exchange Act, the DOJ instead charged Chastain with wire fraud ²³ and money laundering, ²⁴ notwithstanding Chastain's purported conduct having many of the hallmarks of the misappropriation theory.

"Insider Trading" Outside the Exchange Act

The DOJ's use of the mail and wire fraud statutes to prosecute "insider trading" is certainly not without precedent. ²⁵

In a strikingly similar set of circumstances, the U.S. Supreme Court in Carpenter upheld R. Foster Winans' mail fraud, wire fraud, and Exchange Act convictions. ²⁶ There, Winans purchased securities that he recommended in his daily Wall Street Journal column prior to its publication, and after it was published he sold those securities, profiting from the increased demand sparked by his column's recommendations. ²⁷ On the mail and wire fraud counts, the Court saw Winans' use of the Journal's property—its confidential business information on the column's contents prior to publication—for his own benefit as an embezzlement prohibited by the mail and wire fraud statutes. Because Winans purchased publicly traded stocks, Winans' fraud was considered "in connection with a purchase or sale of securities," and his conviction under the Exchange Act was consequently upheld. ²⁸

With respect to Winans' conviction under the Exchange Act, the clear difference between Chastain's and Winans' schemes is the presence of a thing specifically enumerated as a "security" under the Exchange Act: Winans traded public stocks, definitionally a security under the Exchange Act; Chastain traded NFTs, which have not been added to the definition. ²⁹

Applying Howey...