Non-fungible tokens (NFTs) are digital assets that certify ownership or authenticity of unique digital items, such as digital art, music, or virtual real estate. Stored on blockchain networks, NFTs have not only gained significant attention for their innovation and investment potential but also hold the promise of revolutionizing the digital asset landscape, inspiring a new era of ownership and creativity.
However, like any emerging technology, NFTs have also become a target for fraudulent activity. Understanding these schemes is essential when navigating NFT-related challenges, and it's crucial to remain vigilant in the face of potential fraud.
NFT fraud attempts to capitalize on the limited regulation and widespread misunderstanding of blockchain technology. However, investigators are becoming increasingly skilled at identifying and prosecuting this type of fraud under existing federal statutes, providing a sense of reassurance and confidence in the market.
Simply put, Non-Fungible Tokens (NFTs) are digital assets that are recorded on a blockchain that supports smart contract programming, such as the ERC-721 standard on the Ethereum blockchain. There are also other blockchains, such as Polygon, Solana, and Cardano.
NFTs, essentially digital certificates, have the potential to represent ownership of unique assets, including real-world assets such as real estate, collectibles, luxury goods, and other tangible items. This unique feature of NFTs sparks intrigue and interest in the technology, as it opens up new possibilities for ownership in the digital age. Recently, Forbes estimates the market capitalization of the global NFT market to be approximately $70 billion, making it a prime target for fraudsters and scammers.
How are NFTs Abused?
The widespread creation of tokens and the websites that sell NFTs has resulted in a significant amount of fraudulent criminal activity. This has led to millions of dollars in losses for investors in NFTs. Furthermore, NFT projects have been duped into purchasing fake NFTs or have unknowingly provided their login credentials to fraudsters via fake NFT exchange sites.
The Securities and Exchange Commission (SEC) is vigilantly monitoring NFTs, particularly those being offered without prior registration. This oversight provides a safety net for investors, ensuring that those aware of NFT fraud or unregistered NFT offerings can report their concerns to regulators and potentially receive an award following a successful enforcement action. This proactive approach enhances the security of the NFT market, instilling confidence in investors.
The SEC will use the Howey Test to determine if an investment contract is a security, and thus sales of those contracts should be regulated as offerings of securities.
This test, which considers if the transaction involves an investment of money, whether investors expect to profit from the investment through the efforts of others, and if the investment is in a common enterprise, is a key tool in the SEC's regulatory arsenal. In simpler terms, it helps determine if an NFT is a security.
NFT Securities Violations
As noted, if an NFT represents real-world assets, such as real estate or a business, and investors expect a profit, an NFT that promises future dividends, royalties, or other financial gains may be considered a security under certain circumstances. They may need to be registered with the relevant authorities.
Failure to register an NFT such as this could be considered a violation of Section 5 of the Securities Act of 1933, which prohibits the offer or sale of securities unless an active registration statement has been filed with the SEC. Other Securities Act violations include the following:
- Making false or misleading statements in the offer or sale of securities,
- Failing to provide material information to investors, or
- Engaging in fraudulent or manipulative practices in connection with the offer or sale of securities.
The SEC is focusing on the programming of NFTs as part of its review. Specifically, they are looking at the inclusion of royalty fees for the issuer on secondary market sales. They claim this mechanism creates an incentive for investors to buy and sell NFTs, further solidifying their classification as securities.
Common Types of NFT Fraud
NFT fraud can take a variety of forms, but most are parallel to the same types of fraud involving physical assets. For instance, fake or stolen NFTs, pump-and-dump schemes, rug pulls, phishing scams, and wash trading are some of the more common types. Let's delve into these in more detail.
- Fake or Stolen NFTs. One of the simplest yet most harmful types of fraud involves selling fake or stolen non-fungible tokens (NFTs). Fraudsters may create counterfeit versions of popular NFTs and list them on marketplaces, often using fake accounts to pose as the original creators. Alternatively, they might use stolen digital content, such as artwork or photography, without the creator's permission. The fake tokens are then listed for sale on major marketplaces, often accompanied by fraudulent claims about authorship or rarity.
- Pump-and-Dump Schemes. Pump-and-dump schemes in the NFT world mirror those seen in traditional securities fraud. Here, a person or group artificially inflates the value of an NFT or NFT collection through misleading marketing, coordinated purchases, or false claims of celebrity endorsement. Once prices rise due to hype, the perpetrators sell off their holdings at a profit and abandon the project, leaving other buyers with tokens that quickly lose value. Victims are left with devalued tokens they may have purchased at peak prices.
- Rug Pulls. A rug pull occurs when developers or creators of an NFT project suddenly disappear after raising significant funds. They may promise a next-generation game, a metaverse, or highly valuable perks tied to the NFTs. Once they've generated enough sales, they abandon the project entirely, leaving buyers with worthless assets. Unlike legitimate startups that may fail due to market conditions, rug pulls are typically premeditated and intentional. The creators have no intention of delivering a viable product and disappear with the funds shortly after launch.
- Phishing Scams. Phishing scams are rampant in the NFT space, often targeting users' digital wallets. Fraudsters may create fake websites or send fraudulent emails that appear to be from official NFT marketplaces. These prompts often direct victims to enter their private keys or seed phrases, granting scammers full access to their wallets. Once inside, they can steal NFTs, cryptocurrencies, or other digital assets.
- Wash Trading. In such schemes, a small group of people buy and sell NFTs among themselves to create a false sense of demand, thereby increasing the price others are willing to pay.
- Misleading Claims. Scammers make misleading claims about the future value of an NFT, such as promising unrealistic returns on investment.
- NFT Giveaways or Airdrops. Scammers may offer fake NFT giveaways or airdrops to collect personal information or require users to connect their wallets to their accounts.
There are other tactics employed by scammers, including social engineering and dating scams, which aim to manipulate individuals into disclosing sensitive information that can be exploited and used against them. For instance, scammers might pose as a well-known NFT creator or platform and ask for personal information or funds, or they might create fake NFT marketplaces that steal users' login credentials.
SEC Whistleblower Program
Whistleblowers play a vital role in identifying and preventing NFT fraud and scams. These are typically insiders, such as developers or contributors who have intimate knowledge about an NFT project, including its underlying programming or intent to defraud investors.
By reporting their concerns to the SEC, whistleblowers can help minimize the harm to investors, preserve the integrity of various markets, and hold perpetrators of NFT fraud accountable.
The SEC Whistleblower Program was established in July 2010, as outlined in Section 922 of the Dodd-Frank Act, which provides monetary awards to eligible individuals who submit high-quality, original information to the Commission that leads to an enforcement action exceeding $1 million in value. This award is up to 30% of the collected funds, which depends on various factors.
Additionally, under the Dodd-Frank Act, whistleblowers are protected from retaliation. Meaning an employer or fraudster may not discharge, demote, suspend, or harass a whistleblower for engaging in a protected activity, such as reporting concerns to the SEC or assisting in an investigation.
Federal Prosecution of NFT Fraud
Although NFTs are relatively new, the legal tools used to prosecute related fraud are well-established. Federal authorities typically rely on traditional fraud statutes to charge individuals suspected of wrongdoing in the NFT space. The specific statute(s) used will depend largely on the type of scheme being prosecuted. Common charges include:
- Wire Fraud (18 U.S.C. § 1343): Involves using electronic communication, like the internet or email, to carry out a fraudulent scheme, such as selling fake NFTs to U.S.-based buyers.
- Securities Fraud (15 U.S.C. §§ 78j & 78ff): Applies when NFTs are marketed as investment opportunities promising returns, potentially classifying them as unregistered securities. Manipulating or hyping their value could lead to securities fraud charges.
- Money Laundering (18 U.S.C. § 1956): Occurs when NFT marketplaces are used to obscure the origins of illegal funds, such as funneling stolen cryptocurrency or using NFTs to "clean" dirty money.
Increased Focus on NFT Fraud
Federal authorities, including the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC), are taking an increasingly aggressive stance on NFT fraud.
Recent investigations and prosecutions highlight the government's commitment to regulating this space. Specialized task forces are being formed to trace fraudulent activity using blockchain analytics and digital forensics.
If you're under investigation for NFT fraud, you're likely facing a sophisticated system of law enforcement agencies armed with advanced technology. It's an intimidating process with high stakes, and being unprepared could lead to severe consequences.
Your best hope of minimizing penalties and obtaining a favorable outcome is with the help of a federal criminal defense attorney with experience in fraud cases. For additional information, contact our federal criminal defense law firm, Eisner Gorin LLP, located in Los Angeles, CA.
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