PROSECUTING NFT CRIMES: COMBATTING THE TROLLS OF WALL STREET

A nonfungible token, or NFT, sold for $69.3 million.[1]  This NFT was a piece of digital art composed of 5,000 images and created by Beeple, a 41-year-old illustrator from Wisconsin.[2]  NFTs like the one sold for $69.3 million are gaining a lot of mainstream attention and the news of such a large sale brought a lot of entrepreneurial and criminal activity to the marketplace. 

The Manhattan District Attorney Office posted on their website a statement warning the public of the scams surrounding NFTs.[3]  The office described NFTs as “unique bits of code (hashed “smart contracts”) that are typically … stored on the publicly-accessible Ethereum blockchain”, and these “smart contracts” are connected to a piece of content like a digital piece of art or a sports highlight.[4]  The issue with NFTs is you cannot certify its authenticity and what could seem to be a reputable exchange could be a platform for counterfeits.[5] Counterfeits are not the only concern when dealing with NFT transactions; people are also falling victim for phishing sites that mimic reputable NFT websites to steal log-in credentials.[6]  The office also warned about people promoting NFTs on Twitter or Discord, because individuals are artificially raising the value of NFTs and maximizing profits before ultimately dumping it and leaving the others to suffer the subsequent decline in value.[7]  These scams of pumping and dumping NFTs are hard to prove,  because NFTs are not backed by any company and no US regulatory agency has the power to prosecute these crimes.[8]

One NFT owner fell victim to hackers by transferring ownership of 3 NFTs with an estimated worth of $136,000, because the owner thought the hackers were helping him troubleshoot a problem with his cryptocurrency wallet.[9]  NFT crimes like these have lawyers speculating how the US government will react and what kind of regulations will be enacted to safeguard the public.  One thread of speculation predicts that NFTs will be a “commodity” under the Commodity Exchange Act (“CEA”).[10]  Under the CEA, a commodity is a catch-all term for “all other goods and articles.”[11]  If NFTs were to fall under the umbrella of the CEA as a commodity,  then the Commodity Futures trading Commission (“CFTC”) could regulate NFT exchanges for deceptive or manipulative trading and pursue civil action against violators.[12] 

Another thread of speculation is that NFTs could be considered “securities” if they were designed to provide an expectation of profit to a buyer based on the efforts of others and were marketed as such.[13]  One example of how a NFT could be a security is if it were a “fractional” NFT (“f-NFT”), where an investor would share a partial interest in an NFT with others.[14]  These f-NFTs could be considered “investment contracts” under the Howey Test [TB1] and common securities law would be in play.[15]  The Howey test is how the United States Supreme Court defined an “investment contract” under the Securities Act of 1933.[7]  The Court defined an “investment contract” as “a contract, transaction or scheme whereby a person invest[s] his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”[8]  In 2020, the SEC sought to enjoin Telegram Group Inc. from engaging in a plan to distribute “Grams,” a new cryptocurrency, because the SEC believed it was an unregistered offering of securities.[9]  The New York Southern District Court held that the SEC showed a substantial likelihood of success in proving that the offering of cryptocurrencies fell under the Howey test.[10]  The Court agreed with the SEC and held that in the context of the scheme, the resale of Grams into the secondary public market would be an integral part of the sale of securities without a required registration statement.[11]  The New York Southern District Court’s application of the Howey test to the sale of cryptocurrencies is seen as a groundbreaking decision in cryptocurrency enforcement and opens the door for the SEC to intensify enforcement efforts in the cryptocurrency The Howey test is how the United States Supreme Court defined an “investment contract” under the Securities Act of 1933.[16]  The Court defined an “investment contract” as “a contract, transaction or scheme whereby a person invest[s] his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”[17] If these f-NFTs were held by a Court as “investment contracts” under the Howey test then the Securities Exchange Commission (“SEC”) would have the authority to regulate f-NFTs and investigate deceptive or manipulative NFT exchanges.[18]

Currently it is unclear on where NFTs stand as a financial instrument, but that has not stopped private companies from taking action against scammers  The Southern District of New York granted a preliminary injunction against a website that was selling fake Playboy Rabbitars NFTs on two counterfeit websites.[19]  Playboy filed a complaint under the Lanham Act (15 U.S.C. §§ 1114, 1125(a), 1116), and trademark and unfair competition under New York common law.[20]  The court held that Playboy is likely [TB2] [JS3] to succeed on the merits of these claims, because Playboy owns the registered Playboy Marks, demonstrated prior use of the common-law Rabbitars Mark in connection with NFTs and the defendants’ fraudulent scheme involved counterfeiting those exact trademarks.[21]  The court’s holding could pave the way for future lawsuits for private citizens and businesses to purse civil action under trademark infringement against NFT hackers. 

            The Southern District of New York’s decision to grant a preliminary injunction against the selling of counterfeit NFTs starts to form the future of NFT regulation and prosecution.  With the rise of NFT popularity and criminal activity more cases like the one in the Southern District of New York will appear.  It is still too early to tell if other forms of NFTs will be classified as commodities or securities but movement towards regulation and prosecution is imminent for NFT hackers and fraudsters.

[1] Abram Brown, Beeple NFT Sells for $69.3 Million, Becoming Most-Expensive Ever, Forbes (Mar. 11, 2021, 10:03 AM), https://www.forbes.com/sites/abrambrown/2021/03/11/beeple-art-sells-for-693-million-becoming-most-expensive-nft-ever/?sh=5c0ae8fb2448.

[2] Id.

[3] NFT Scams and Frauds, Manhattan District Attorney’s Office, https://www.manhattanda.org/nft-scams-and-frauds/.

[4] Id.; see also Gary DeWaal, NFTs Are Hot, But Patchwork of Laws, Rules Needs Watching, Bloomberg Law (Apr. 6, 2021, 4:00 AM), https://news.bloomberglaw.com/white-collar-and-criminal-law/nfts-are-hot-but-patchwork-of-laws-rules-needs-watching (a NFT highlight card featuring a dunk by Lebron James for $200,000)

[5] Id.

[6] Id.

[7] Id.

[8] DeWaal, supra note 4.

[9] Lorenzo Franceshi-Bicchierai, Man Upset That Hackers Stole His Bored Ape NFTs, Vice (Nov. 3, 2021, 9:00 AM) https://www.vice.com/en/article/qjb4nq/investor-says-bored-ape-nfts-were-stolen-by-hackers.

[10] NFTs: Keys U.S. Legal Considerations for an Emerging Asset Class, Jones Day (April 2021), https://www.jonesday.com/en/insights/2021/04/nfts-key-us-legal-considerations-for-an-emerging-asset-class.

[11] Id.

[12] Id. see also Enforcement, Commodity Futures Trading Commission, https://ww.cftc.gov/LawRegulation/Enforcement/OfficeDirectorEnfrocement.html.

[13] Jones Day supra note 10.

[14] Id.

[15] Id.

[16] SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

[17] SEC v. Telegram Grp. Inc., 448 F. Supp. 3d 354, 365 (S.D.N.Y. 2020) (citing SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946).

[18] Id.; see generally Securities Exchange Act of 1934.

[19] Playboy Enters. Int’l v. www.playboyrabbitars.app, 21 Civ. 08932 (VM), 2021 U.S. Dist. LEXIS 222422 (S.D.N.Y. November 13, 2021).

[20] Id. at 1.

[21] Id. at 3-4.