By Andrea Gordon, Sarah Paul, and Adam Pollet
Eversheds Sutherland attorneys examine the DOJ’s and SEC’s enforcement activity involving non-fungible tokens, or NFTs. Companies need to take time now to understand the various regulatory risks to prevent serious issues down the road, they say.
The Department of Justice, the Securities and Exchange Commission, and other regulators are coming for non-fungible tokens.
Earlier this year, the DOJ indicted Nathaniel Chastain, a former employee of an NFT marketplace in what was the first NFT insider trading case. The SEC has also been busy, reportedly issuing subpoenas to NFT creators and crypto exchanges to determine whether NFTs are being used to raise money like traditional securities.
While many companies are understandably excited to explore and use Web3, the DOJ has been clear: “Web3 is not a law free zone.”
Irrespective of how a company may want to leverage NFTs—to transact or to promote products and engage users—they should take the time to understand (and address) the various regulatory risks surrounding NFTs beforehand.
The DOJ and other regulators are intent on identifying and prosecuting illicit activity involving NFTs. One recurring theme in these efforts has been whether and when NFTs are securities.
NFTs are, by definition, non-fungible (i.e., unique). Because NFTs are not interchangeable, the DOJ and SEC could have difficulty establishing that an NFT is subject to federal securities regulation.
To date, neither the DOJ or SEC have directly addressed whether or when an NFT is a security. But that isn’t stopping the DOJ from pursuing illicit conduct historically associated with securities fraud.
In the Chastain case, the DOJ dodged the issue by opting to indict using a wire fraud charge instead of the securities laws traditionally used in insider trading cases.
But companies won’t be able to sidestep securities laws simply by claiming a digital asset is an NFT. As SEC Chair Gary Gensler has said, the SEC is “not concerned with labels, but rather the economic realities of an offering.”
State securities regulators have pursued enforcement actions precisely on this basis. Despite a company’s claims to the contrary, the NFTs at issue were deemed securities and subject to regulation.
While the SEC itself has not brought any enforcement actions involving NFTs, these are most certainly on the horizon. The SEC’s announcement in May that it was expanding its Crypto Assets and Cyber Unit highlights its focus on NFTs.
In addition, earlier this year the SEC reportedly issued subpoenas seeking information about how NFT creators and crypto exchanges are using NFTs, including fractional NFTs. These FNFTs, which are “fractions” of a single NFT, are more likely to be deemed securities because, unlike NFTs, they are not unique and are interchangeable.
The DOJ may also zero in on prosecuting the use of (and failure to prevent the use of) NFTs to launder the proceeds of illicit activity. Bad actors often use expensive real estate and art to launder funds because of their high value, and NFTs can act as a similar conduit for large sums of money. For example, “The First 5000 Days,” an NFT created by artist Beeple, sold for $69 million in 2021.
Coupled with the relative anonymity of transferring NFTs on the blockchain, NFTs have the potential to be an effective mechanism to “clean” illicitly obtained funds.
The DOJ also could take action against platforms facilitating NFT transactions for not acting in accordance with anti-money laundering laws. The government has already suggested that such platforms may be subject to AML laws if NFTs are a “value that substitutes for currency,” and there is increasing pressure for legislation or regulation that expressly brings these platforms within their purview.
For example, Attorney General Merrick Garland is advocating for Congress to amend AML laws so that they unambiguously apply to platforms selling NFTs. The government is also considering whether AML laws applicable to those engaged in the “trade of antiquities” could extend to those engaged in NFT purchases, sales, and transfers.
Before diving into Web3 by exploring NFTs, companies should consider taking certain steps to try and stay off the DOJ’s and other regulators’ radar.
First, companies would be wise to carefully assess their compliance program to ensure it is in line with DOJ expectations as set forth in the Evaluation for Corporate Compliance Programs.
Next, to avoid inadvertently issuing a security in the form of an NFT, businesses using NFTs (and digital assets generally) should consider whether the asset has characteristics that arguably render it a security. For example, a company could consider avoiding actions that could impact the NFT’s market price and prohibiting fractionalization of the NFT.
Finally, companies involved in facilitating NFT transactions should implement “Know Your Customer” policies and controls to ensure sufficient due diligence. This includes sanctions screening and transaction monitoring, is being conducted at onboarding and on an ongoing basis.
The DOJ and other regulators are focused on NFTs, and more NFT-related prosecutions and enforcement actions are inevitable. Taking steps now will help avoid issues down the road.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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Andrea Gordon is counsel at Eversheds Sutherland in the Washington DC office. She advises clients on white collar, compliance, SEC, and FINRA matters.
Sarah Paul is a partner at Eversheds Sutherland in the New York office. Her practice spans all areas of white-collar defense, with a particular focus on government, internal, and cross-border investigations, tax controversy, and cybersecurity and privacy law.
Adam Pollet is a partner at Eversheds Sutherland in the Washington DC office. He defends financial institutions, broker-dealers, investment advisers and individuals in regulatory investigations and enforcement matters involving the SEC, FINRA and state securities regulators.
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