Last month accusations emerged that an executive at OpenSea, a leading Non-Fungible Tokens (NFT) sales platform, was possibly front-running sales by buying drops before they were listed on OpenSea’s main page and then selling them after they had been publicized by OpenSea. Such use of insider information, if true, would seem to be a classic violation of securities laws prohibiting insider trading. Or rather it would be if there were any clarity regarding whether NFTs are securities at all. Let’s take a closer look at NFTs, securities fraud, and insider trading.
What is a Security?
The SEC was created to regulate the sale of “investment contracts,” and the question arose quite quickly as to what constituted an “investment contract,” or a “security.” The Supreme Court case that delivered the first definitive answer on this was SEC v. W. J. Howey. That matter involved the sale of contracts that would provide the purchaser with a share of the proceeds in the profits of Florida orange groves. The Supreme Court held that these contracts were securities and announced a three-part test regarding what would be considered a “security.” A security is (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profit to be derived from the effort of others. In other words, the orange trees themselves were not securities, but investment contracts that purported to provide investors with a share of the profits from the orange growers’ activities were.
Are NFTs Securities?
How does this translate to NFTs? On the one hand, NFTs are tokens and so far, the SEC has not taken the view that tokens by themselves, are securities. But lately, the SEC is taking a more nuanced view, asking what the token really represents. The most prominent example is the action the SEC is taking with regards to Ripple. The SEC has taken the view that Ripple’s efforts to promote its token and manage its availability make it akin to security. This is in opposition to tokens like Bitcoin or Ethereum that lack central promotion or management.
It is my belief that the SEC will take the view that at least some NFTs are securities. Take one of the most notable NFT issues of the year: Bored Ape Yacht Club. While purchasers of BAYCNFTs are just purchasing individual tokens, there is a central organization managing the availability of BAYC, its various spinoffs, the membership benefits, and their overall market value. I believe there is a good chance the SEC will take the view that BAYC Apes function in much the same way as Ripple tokens, even though each individual Ape has its own market. This likelihood only increases if market makers like OpenSea misbehave.
What is Insider Trading?
Insider trading is a term that most people in the investment community have a passing familiarity with, but what does it mean, legally speaking? The body of case law surrounding insider trading is complex, but a good shorthand would be the misuse of confidential information for one’s own personal gain. The case that comes to my mind when reading about the OpenSea situation is U.S. v. Carpenter, a Supreme Court case from 1986. In that matter, the Court upheld mail and wire fraud convictions for a defendant who had been tipped by a fellow Wall Street Journal writer regarding columns that would appear in the Journal. This seems akin to trading in NFTs in advance of their promotion on OpenSea to the front page of the Wall Street Journal. This is, without doubt, a case that bears monitoring.
Summing it All Up
The NFT industry is ever-changing, as is the government’s regulation of the industry. If you are operating within the industry and are seeking legal advice or have invested in NFTs and believe you have been defrauded, please contact us for a free consultation at 848.202.9323 or email us at email@example.com. Please note that any legal question requires consideration of individual facts and this article is not intended as legal advice to any particular individual or business, and should not be relied upon as such.