NFT Scandals Coincide with Increased Push for Crypto Regulation | BakerHostetler

Problems caused by the lack of regulation in NFT markets were clearly exposed just last month with the revelation of not one, but two NFT scandals involving the use of insider information to snag exclusive pieces and game the market. In early September, a social media user claimed that an Art Blocks employee had purchased one of an artist’s few exclusive NFT works slated for public feature. Art Blocks’ CEO and founder, Erick Calderon, later responded that he agreed guidelines needed to be established to get ahead of those situations.[1]

Merely one week later, on September 15, a Twitter user and NFT trader and collector accused an OpenSea employee of frontrunning the popular NFT marketplace’s products similar to the way a broker might do with a stock. The user noticed that the $1.5 billion startup’s head of products, Nate Chastain, appeared to use several secret Ethereum wallets to buy exclusive NFT drops before they were officially listed on the website for purchase. The user claimed that Chastain later sold the NFTs when prices spiked upon their official release and funneled the profits back to his personal Ethereum wallets. Shortly after the accusations broke, OpenSea admitted that an employee had misused non-public information and implemented new policies that restrict certain employee transactions on NFT platforms.[2]

While the tech-savvy community has charged itself with policing suspicious NFT activity in search of any insight into the next hottest NFT project, the NFT controversies come amongst calls by government officials to increase crypto regulation. On September 14 – one day before the OpenSea accusations broke – Securities and Exchange Commission (“SEC”) Charmain Gary Gensler assured lawmakers that he was working to create rules to regulate cryptocurrencies and consequently, the value of NFTs. Testifying before Congress, Gensler stated, “[c]urrently, we just don’t have enough investor protection in crypto finance, issuance, trading, or lending . . . [f]rankly, at this time, it’s more like the Wild West or the old world of ‘buyer beware’ that existed before the securities laws were enacted.” [3]  Gensler also highlighted that some digital asset platforms were already offering securities which have brought them within the SEC’s oversight, but lawmakers pressured Gensler to clarify a framework – and quickly.[4]

These discussions come just weeks after the SEC threatened to sue Coinbase, the nation’s largest cryptocurrency exchange, if it proceeded with its plan to offer investors interest for lending their crypto assets. [5] At the same time, the SEC brought an action against BitConnect, an online crypto lending platform, its founder and others, alleging that they defrauded investors out of $2 billion through a fraudulent unregistered offering in the form of a “lending program.” The complaint alleged that the defendants induced investors to depart with their funds through a network of paid promoters and then siphoned off the funds to wallets they controlled for personal use.[6]

The explosion of crypto assets like NFTs and the tangible demonstration of their misuse have also attracted the attention of the Treasury Department, which has demanded assurances that stablecoin firms have the technical capacity to handle large surges in transactions. Federal officials claim they are considering using expansive powers under Dodd-Frank to subject them to federal regulation. This review will culminate in a report with recommendations this fall and will likely serve as a template for potential regulation in the coming year.[7] The U.S. Department of Justice has also demonstrated an increased focus on the cryptocurrency industry, having recently announced “the creation of a National Cryptocurrency Enforcement Team (NCET), to tackle complex investigations and prosecutions of criminal misuses of cryptocurrency.”[8]

While nothing is certain about cryptocurrency regulations except the uncertain nature of the assets themselves, purveyors of digital art can best prepare for any impending guidance by:

• Refraining from engaging in transactions of NFTs to which he/she may be privy to confidential information;
• Conducting diligence of the NFT, the offering platform’s practices, and recent press prior to engaging in the transaction; and
• Retaining all documentation regarding the transaction in the event of required information disclosure or tax reporting.

[1] Shanti Escalante De-Mattei, Insider Trading on NFT Marketplaces Spikes Concern Over Regulation, Artnews, Sept. 17, 2021, https://www.artnews.com/art-news/news/insider-trading-nft-marketplaces-regulation-1234604209/.

[2] Id.

[3] Gary Gensler, Chair, U.S. Sec. & Exch. Comm’n, Testimony Before the United States Senate Committee on Banking, Housing, and Urban Affairs (Sept. 14, 2021).

[4] Chris Matthews, Sen. Pat Toomey presses SEC Chair Gensler for crypto clarity, MarketWatch, Sept. 24, 2021. https://www.marketwatch.com/story/sen-pat-toomey-presses-sec-chair-gensler-for-crypto-clarity-11632514494.

[5] Hazma Shaban & Tory Newmyer, Coinbase CEO says SEC has threatened to sue over crypto lending program, Sept. 8, 2021, https://www.washingtonpost.com/business/2021/09/08/coinbase-sec-wells-notice/.

[6] Complaint, SEC v. BitConnect, et al, No. 21-Civ-7359 (S.D.N.Y. Sept. 1, 2021).

[7] Eric Lipton, Ephrat Livni, & Jeanna Smialek, Regulators Racing Towards First Major Rules on Cryptocurrency, Sept. 24, 2021, https://www.nytimes.com/2021/09/23/us/politics/cryptocurrency-regulators-rules.html.

[8] Press Release, U.S. Dep’t of Just., “Deputy Attorney General Lisa O. Monaco Announces National Cryptocurrency Enforcement Team” (Oct. 6, 2021), https://www.justice.gov/opa/pr/deputy-attorney-general-lisa-o-monaco-announces-national-cryptocurrency-enforcement-team.