On 3 May 2023, a court in New York handed down what could be a precedent-setting ruling when a former product manager at OpenSea, the world’s largest NFT marketplace, was found guilty of fraud and money laundering.
In an industry, whose regulation to date can charitably be described as “piecemeal” (although the recently approved EU MiCA regulation is looking to possibly change that), this looks to be an example of US courts leveraging existing rules to this new technology. This was quickly followed up by New York’s top regulator proposing new legislation to address these, and other, issues.
NFTs (“Non-Fungible Tokens”) are digital assets implemented using blockchain technology. As each NFT is unique, and can’t be duplicated or divided, they are often used to represent collectibles, particularly artwork (such as the well-known “Bored Ape Yacht Club”, and “Cryptopunks” collections). These are typically traded on marketplaces, of which OpenSea is the largest and most well-known. While NFTs remain on the blockchain, governed by smart contracts, platforms like OpenSea operate as a sort of marketplace which provides a more user friendly interface to the blockchain.
The popularity of NFTs hit a peak in early 2022, with trading volumes reaching $17bn in January (and the likes of Jimmy Kimmel and Paris Hilton getting in on the act), though they have sharply shrunk since.
In terms of the crime itself, this took place in early 2021. Nate Chastain worked as a product manager at OpenSea. The allegation by prosecutors was that, between June and September, he repeatedly purchased tokens prior to their being listed on OpenSea, and that he did so in the knowledge that, upon being listed on the platform’s homepage, their value would increase, and he’d be able to profit from this. The 45 NFTs in question typically sold for between 2-5x the initial price.
Following a tip-off by a user who had observed the suspicious transactions, OpenSea launched an investigation. This subsequently led to his being charged in June 2022 with wire fraud and money laundering, and his subsequent guilty verdict last week.
What can we learn from this case?
Although the court was very careful to avoid making any specific findings regarding the nature of crypto-assets and their regulation, there are some things that we might learn from this case.
Making whole cloth out of patchy regulation
Mr Chastain was not charged with insider trading under existing securities and commodities regulation specifically, but wire fraud and money laundering. This is likely because of the patchy and ambiguous regulatory framework surrounding NFTs, so much so that Mr Chastain’s legal team attempted to get the case dismissed on these grounds.
This is something that will likely change in the future, as regulatory bodies worldwide start to develop specific regulation to remove these ambiguities (something that members of the crypto industry are strongly arguing for). However, by being able to obtain a conviction in this case, the New York prosecutors have been able to demonstrate that this kind of “insider trading” is something that the US courts are able to address using existing frameworks.
Another lesson in governance for the crypto industry?
Part of Mr. Chastain’s defence was in the claim that OpenSea had no training or policies in place prohibiting his actions. For those of us who work in professional services firms and regulated industries, and have these policies regularly reinforced through mandatory annual training, this might sound unusual, but it might be a consequence of the relative maturity of the digital asset industry versus the traditional financial system.
The ecosystem has developed from a “tech-first” perspective, where compliance and other regulatory considerations can from time to time be found left by the wayside. Rapid growth, excitement, and regulatory ambiguity push companies to “build-first, ask questions later.” As we’ve seen, doing this with instruments that are increasingly under the purview of financial regulators, some of the toughest, isn’t a sustainable approach.
Much like how reputable custodial exchanges now implement basic financial crime controls such as Know Your Customer checks and sanctions screening, and have long since learned the life lessons of the Mt Gox hack and subsequent collapse, as well as the high-profile collapses last year from the crypto winter, this may stand as another reminder of the controls and procedures that are required in an industry of this type. Arguably OpenSea and their competitors have learned this lesson more cheaply than most.
The power of the consumer to investigate
Typically, insider trading cases come to light due to a combination of whistleblowers, in-house compliance functions, or market surveillance by bodies such as the SEC. However, in this instance, a user of the exchange platform was able to use publicly available blockchain data to identify the suspicious transactions and trace the beneficiary back to Mr. Chastain. They then opted to share this information publicly with OpenSea via Twitter.
Although there are definite moral questions about the ethicality of making a public accusation of insider trading via social media, this case does demonstrate that the public nature of most popular blockchains does present more opportunities for this type of behaviour to be identified and spotted. Thinking about it from a litigator’s perspective, it could be almost perfect evidence – a verifiable, immutable trail of activity, assuming you can prove the individual’s control over the wallet at the time.
Where do we go from here?
It’s not a particularly controversial take to say that lawmakers and regulators worldwide have been playing catch-up for the past few years, with all-encompassing crypto-asset regulation still not in place. Although moves are being made, the EU’s MiCA regulation isn’t expected to be implemented until the end of 2024, and the UK Treasury’s own consultation on a regulatory regime only recently closed last month.
In the meantime, we’ll probably continue to see creativity on the parts of courts and regulators to use existing powers and frameworks (we’ve seen in the past, for example, regulators as diverse at the UK’s Advertising Standards Authority weighing in cryptocurrency advertisements). And on the flip side of the coin, we’ll see those in the digital assets industry learning the lessons of those who fell on the wrong side of the law, to avoid making the same mistakes.
Our deep bench of experts have worked in blockchain forensics for years, tracing and deanonymizing crypto transactions, identifying related entities, and documenting potential subpoena targets. Our capabilities in digital forensics and forensic accounting also give us the tools and expertise needed to reconstruct books and records and reconcile this with on-chain activity. We have worked on some of the world’s most complex, intricate investigations, valuation disputes, bankruptcies, liquidations, and accounting matters that positions us to address issues in the digital asset space. Our firm regularly serves as external, trusted advisors to executives and counsel seeking assistance to address their most pressing issues.