Instances of alleged “insider trading” are popping up in the web3 space, with individuals close to budding deals for non-fungible tokens (“NFTs”) reportedly racing to cash in ahead of information being made public. Last fall, for example, OpenSea confirmed that one of its employees used internal information to buy NFTs that were slated to be featured on the homepage of the NFT marketplace, a move that caused the prices of the NFTs to surge. In response and in addition to launching an internal review in September 2021, the marketplace implemented policies prohibiting its “team members” from “using confidential information to purchase or sell any NFTs, whether available on the OpenSea platform or not,” among other things.
Fast forward to this month, and accusations of foul play have been raised on social media in connection with Yuga Labs’ recent acquisition of the CryptoPunks and Meebits NFTs from Larva Labs, with one individual that allegedly had advance notice of the Larva Labs deal acquiring two Meebits NFTs a little over a week before the headline-making transaction was announced, again prompting claims of “insider trading” in the NFT space.
In both instances, the allegations of “insider trading” of NFTs came about thanks to eagle-eyed social media users spotting closely-timed transactions by individuals who appeared to have access to insider information – and thanks, of course, to the publicly-available records for NFT transactions hosted on the Ethereum blockchain. Last year, BBC stated in connection with the OpenSea scandal that “crypto traders noticed that an anonymous user was regularly buying items from the public marketplace shortly before they were promoted on the site’s front page, a prestigious slot that often brings significant interest from would-be buyers. The anonymous user would then sell the assets on, making vast sums in a matter of hours.”
The Meebits transactions in question saw someone who is alleged to have had access to information about Larva Labs buy up the NFTs nine days before Yuga Labs announced its acquisition of the CryptoPunks and Meebits NFTs from Larva.
Is This Insider Trading?
In being likened to insider trading, these instances raise a threshold question of whether the NFTs at issue in these scenarios are actually securities in the first place. After all, in order for insider trading (i.e., the trading of a company’s stocks – or other securities – by individuals with access to confidential or non-public information about the company) to take place, there must be a security at play.
“By their nature, NFTs can be linked to a variety of different assets and represent numerous rights and obligations, making them challenging to classify,” according to a note from law firm Jones Day. “If an NFT is considered a security, then common securities law issues would be present (e.g., registration or exemption of the offering under the Securities Act of 1933); registration of the sellers of those instruments as broker-dealers under the Securities Exchange Act of 1934; registration of the marketplaces on which the instruments are sold as securities exchanges under the Exchange Act; securities law liability for material omissions or misstatements and insider trading; restrictions on short sales and market stabilization around an initial offering; and so on.”
To date, neither the U.S. Securities and Exchange Commission (“SEC”) nor U.S. courts have specifically placed NFTs within the realm of securities, which encompasses a broad gambit of instruments that do not need to be fungible in nature. But that does not mean that certain iterations of this relatively novel tech do not function as instruments that have monetary value and can be traded, and that such determinations are not potentially in the pipeline as regulators like the SEC start to focus their attention on the NFT space.
The Potential for SEC Scrutiny
It is likely that at some point, NFTs will fall within the purview of the SEC and that government agency will bring enforcement actions against issuers of NFTs. Jeremy Goldman, who co-chairs the Blockchain Technology Group at Frankfurt Kurnit Klein & Selz, believes that action from the SEC could potentially mirror actions that the agency took in and around 2017 when it began pursuing parties that were offering up fungible digital tokens – or tokens that are entirely exchangeable with each other – by way of initial coin offerings (“ICOs”) on that basis that they were dealing in unregistered securities.
Many existing NFTs, namely those that are used primarily as vehicles for selling the digital art associated with the tokens, “feel different” than the assets being offered up in ICOs, according to Goldman. However, not all NFTs may be in the clear in the eyes of the SEC. Goldman points to a growing number of projects in which as many as “tens of thousands of NFTs” are offered up by issuers, as an example of where the SEC might find that NFTs do, in fact, amount to securities. “The SEC could take the position that these NFT offerings are a pretext for fungible token projects,” or in other words, they “are just another way to raise money for a project or venture where people are making an investment,” Goldman states, noting that whether there is digital art involved would not necessarily change the SEC’s view.
Courts will likely also provide some guidance on this issue. It is also worth noting that at least one pending lawsuit, the putative class action lawsuit that plaintiff Jeeun Friel filed against Dapper Labs in May 2021 alleging that its NBA Top Shot Moments NFTs are unregistered securities, centers on the issue of whether the specific NFTs at issue are securities. Given that the NBA Top Shots NFTs are hosted on a blockchain that is exclusive to Dapper Labs and can only be bought, sold, and traded on that blockchain, which is distinct from how the bulk of other NFTs work, this likely means that any decisions in the case when it comes to the issue of whether the NFTs are securities could have relatively limited precedential value.
While it is not immediately clear whether the NFTs at play in the some of recent instances of alleged “insider trading” are actually securities and thus, whether insider trading is the appropriate claim to be considered, such scenarios may still run afoul of other types of law, including in the realm of fraudulent, unfair, and anti-competitive business practices.
And even beyond that, Goldman claims there is another element of the equation that NFT issuers and big NFT marketplaces should be paying attention to: the optics of such alleged bad acts. These types of practices are “not going to be helpful for the NFT industry,” which is not only in a very nascent space but is also facing pushback in an array of other regards – from claims of Ponzi schemes to instances of widespread infringement and criticism over the effects of NFT minting and trading on the environment. Against this background, Goldman says that the NFT industry simply “does not need the platforms that are helping to drive this [market] allowing employees and insiders to profit off of their information.” Regardless of the legality, he notes, that is just “not a good look” for this burgeoning space.