What the “NFT Indictment” Tells Us About The Trading of Digital Assetsbr>
Insider Trading. Digital assets. On June 1, 2022, the United States Attorney’s Office for the Southern District of New York (the “USAO”) and the Federal Bureau of Investigation (the “FBI”) unsealed an Indictment charging former OpenSea employee Nathaniel Chastain with wire fraud and money laundering in connection with an alleged insider trading scheme in non-fungible tokens (“NFTs”), marking what appears to be the Department of Justice’s (the “DOJ”) first pursuit of an insider trading scheme concerning digital assets. What is also interesting to note is that while this case was investigated by the DOJ’s Securities and Commodities Fraud Task Force, they chose not to charge it as insider trading in securities. This indictment, by omission, may provide some insight into the DOJ’s view that at least certain types of NFTs are not, in fact, securities.
Chastain was a former product manager at OpenSea – the first and largest marketplace for crypto collectables and NFTs. OpenSea routinely features different NFTs at the top of its homepage, and this favorable placement and resulting demand for the featured NFT typically increases the featured NFTs’ value. As a product manager, Chastain was responsible for selecting which NFTs to feature and was required to keep such information confidential, as these decisions were not publicly disclosed until the time of listing. This obligation was memorialized in a written confidentiality agreement with OpenSea, whereby he agreed not to use OpenSea’ confidential business information unless for OpenSea’s benefit or to perform work for OpenSea.
The Indictment alleges Chastain, while employed by OpenSea, misappropriated OpenSea’s confidential business information he obtained by virtue of his role to purchase dozens of NFTs that he knew were going to be featured on OpenSea’s homepage prior to their public listing, then re-sold the NFTs for a profit shortly after they were featured. For instance, on one occasion, Chastain allegedly bought four “The Brawl 2” NFTs shortly before they were featured on OpenSea’s homepage then sold them for double the price hours after being featured. On another occasion, Chastain purchased ten “Flipping and spinning” NFTs before they were featured on OpenSea’s homepage, then sold them at prices 250% to 300% higher after being featured. Over the course of a few months he is alleged to have unlawfully purchased approximately 45 NFTs that he re-sold for anywhere between two to five times his purchase price. Chastain also faces a second charge for money laundering for allegedly attempting to conceal his scheme by creating multiple anonymous wallets and OpenSea accounts, which he used to make the purchases and sales of the NFTs and transfer the ill-gotten gains.
- The Application of Insider Trading Enforcement to Non-Security Digital Assets Is Far-Reaching
Typically, “insider trading” charges are brought under securities regulations pursuant to the Securities and Exchange Commission’s (the “SEC”) Rule 10b-5 or 18 U.S.C. § 1348, or under commodities regulations, pursuant to the Dodd-Frank Act and Commodity Futures Trading Commission’s (the “CFTC”) Rule 180.1. Here, however, the insider trading Chastain allegedly engaged in is not premised on a violation of either securities or commodities regulatory schemes. Rather, it is premised on Chastain having committed wire fraud under 18. U.S.C. § 1343 by using confidential information to trade on NFTs, and money laundering under 18 U.S.C. 1956(a)(1)(B)(i) for trying to conceal it. So how did the DOJ connect insider trading to wire fraud? The DOJ focused on Chastain’s conduct – mainly that he possessed confidential knowledge, traded based on that confidential knowledge, and profited from his acts. While unusual, particularly as to non-securities, it is not unprecedented.
(1) The Courts Have Permitted Insider Trading Charges Premised on Wire Fraud
Case law demonstrates how wire fraud and insider trading can both be brought on the same set of facts, and present intertwined issues. In United States v. Dial, defendant broker and his supervisor were charged with mail and wire fraud for a trading scheme involving silver futures on the Chicago Board of Trade. The broker solicited his customers to participate in block orders, implicitly representing that he would try to get the best prices, but instead placed his own orders ahead of his customers without disclosure of such conduct to his customers. The supervisor was aware of the scheme and participated by arranging for the broker to use a company account, and also profited personally from the plan. Defendants argued that they did not commit fraud because none of their customers or employer suffered damages as a result of their acts and that no statute, regulations, or Board of Trade rule specifically forbade insider trading in commodity futures. The 7th Circuit disagreed. Noting that “federal mail and wire statutes have often been used to plug loopholes in statutes prohibiting specific frauds” and how “the mail fraud statute was applied to insider trading in securities before the promulgation of the SEC’s Rule 10b-5[,]” the 7th Circuit upheld the mail and wire fraud convictions.
Two years later, the Supreme Court faced a similar question. In Carpenter v. United States, the Court considered the case of a Wall Street Journal columnist who was charged with, among other things, insider trading and wire fraud for entering into a trading scheme with stockbrokers. The columnist would first provide advance information from his yet to be published investment advice columns to his co-conspirator stockbrokers, who would then make trades based on that information and share their profits with the columnist. In affirming the Second Circuit’s wire fraud conviction, the Court held that it had “little trouble in holding that the conspiracy [by an employee] to trade on [his company’s] confidential information is not outside the reach of the mail and wire fraud statutes[.]” But interestingly, the Court was evenly split as to the convictions brought under § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, and thus affirmed the Second Circuit’s judgment that the defendants’ “fraud was  ‘in connection with’ a purchase or sale of securities within the meaning of the [securities] statute and [Rule 10b-5].” Carpenter demonstrates that engaging in insider trading on the basis of confidential company information can be a breach of a duty of confidentiality owed to one’s employer, and that such a breach can result in liability under the wire fraud statute.
(2) Elements of Insider Trading Applied
Although trading non-securities and breaching a duty of confidentiality owed to an employer can result in insider trading premised on the wire fraud statute, this analysis still must review whether the elements of insider trading can be met when the underlying asset is a digital asset, which such a theory has not yet been tested before courts. The general legal requisites to support an insider trading violation are (i) possession of material non-public information and (ii) trading in breach of a fiduciary duty or other relationship of trust and confidence. It does not require that the insider trading involve securities or commodities.
The first element is whether the defendant possessed material non-public information. Here, Chastain is alleged to have used his access to OpenSea’s procedures to profit from NFTs that would be featured on the homepage. As alleged, Chastain possessed and traded on material non-public information because he (1) had knowledge of and certain responsibilities to determine which NFTs would be featured on the homepage of OpenSea’s platform, which being featured on the homepage typically increased the value or price of the NFT, (2) purchased certain NFTs shortly before they were featured on the homepage, and (3) sold those NFTs after they were featured on the homepage for a profit. This case will turn on whether an NFT being featured on the homepage was expected to have a positive impact on the NFTs value or price, such that the information was material, and whether a basis for Chastain’s trading was his knowledge of which particular NFTs would be featured and when.
The second element is whether the defendant traded in breach of a fiduciary duty or other relationship of trust and confidence. Assuming that Chastain did purchase and sell NFTs, then the government likely will be able to prove he “traded” the NFTs. The government will seek to prove that Chastain, as alleged, had a duty to maintain the confidentiality of confidential business information received in connection with his work for OpenSea, and a duty to refrain from using such information for his own benefit, including by relying on the signed confidentiality agreement.
III. What Does This Mean For Traders of Digital Assets?
Here are a few takeaways and points for consideration from these charges:
- First, this should put all traders of digital asset holders on notice. While the SEC is still waffling over whether certain, or all, digital assets are securities, it may be a moot point now, at least in the context of insider trading or other trading activities, such as front running, that rely upon the misuse of material non-public confidential information that gives the user an advantage over others. Whether Chastain’s NFTs were a security was irrelevant to the DOJ’s claim that Chastain engaged in insider trading and guilty of wire fraud. This application of wire fraud as to digital assets adds a regulatory scheme that digital asset holders have to consider, in addition to the SEC and CTFC’s use of securities and commodities laws to target the same digital assets. Notably, Chastain’s case is being handled by the DOJ’s Securities and Commodities Fraud Task Force, which suggests the government initiated this case as a possible securities or commodities fraud case, but later determined the easier route was to charge simple wire fraud. One reasonable take away is that the DOJ does not view these types of NFTs as securities, or at least that it would be harder for the government to prove to a jury that this case involved the insider trading of “securities.”
- Second, by utilizing the wire fraud statute to avoid answering whether Chastain’s featured NFTs were securities, the DOJ seemingly announced its intent to use an expansive application of insider trading liability to any situation where confidential information relating to digital assets gives the seller an advantage, regardless of the type of asset involved. Such other activities might include, for example, front running, whereby a buyer purchases tokens knowing that a yet to be announced event or disclosure (such as a listing on a major exchange) likely will cause the token to increase in price upon public disclosure. Such information arguably is material, and thus should not be used by someone with confidentiality obligations.
- Note, Chastain was not actually charged for insider trading. In fact, the DOJ could have written the Indictment without ever trumping in a press release “Employee Of NFT Marketplace Charged In First Ever Digital Asset Insider Trading Scheme.” So what is it trying to signal by charging Chastain with wire fraud and the related count of money laundering, while highlighting insider trading? Undoubtably this is meant as a warning shot to digital asset traders, to put them on notice that the DOJ will be policing the trading of digital assets irrespective of whether it is a security, commodity, or something else.
- Practical Advice for Trading Digital Assets
For funds, companies, DAOs, and all entities and persons engaged in trading digital assets, whether purchasing, selling, or otherwise, this Indictment highlights the need to implement and reassess internal policies, procedures and practices. Some recommendations include:
- Consider whether internal policies around insider trading are warranted, and whether current policies, if any, address expectations of confidentiality and definitions of confidential information. Having written policies, including that all trades need to be pre-cleared by a designated committee or individual in charge of pre-clearing trades, around these topics may, for certain entities, be advisable to provide a stronger buffer should anything go awry.
- Entities should also have educational trainings to inform employees, consultants, or contributors what insider trading and materiality are, how to avoid sharing or trading on material non-public information, and reminding employees, consultants and contributors of the duties of confidentiality and trust that they owe to the company, clients, customers, and other parties. Additionally, companies should stay vigilant and monitor for suspicious behavior that suggest insider trading.
- Consider what is likely to be material information in your business or foundation. In its simplest and most conservative application, it is knowing something that may impact the price of the digital asset. What that means in reality is often challenging and subject to interpretation. The government is likely to view any information about an asset being listed on an exchange before it is public as material. The same with planned purchases or sales of significant amounts of the digital asset. The same may be true of significant positive and negative announcements about a platform, such as a hack or the gain or loss of a major user of the digital asset. What about the departure of a significant contributor, founder or executive? The answer is likely that it depends.
- Consider the same for the types of information that your organization’s members will possess that is likely to be confidential. Is it listing information? Deals? Revenue numbers? Loss of market makers? Loss of contributors to liquidity pools? Information about a portfolio company?
- As for individuals, be sure to review your agreements (look for the confidentiality provisions, if any) and any internal policies regarding insider trading. Understanding what is considered material non-public information and confidential business information, and how you are permitted to use that information will help when navigating temptations similar to the ones Chastain allegedly faced, or to simply avoid a trade that could get you in hot water.