Problems with the NFT “Insider Trading” Case

Last month the U.S. Attorney’s office for the Southern District of New York announced, with considerable fanfare, that it had brought charges in the “first ever digital asset insider trading scheme.” Prosecutors charged the defendant, Nathaniel Chastain, with using inside information to purchase NFTs that were about to be featured on his employer’s digital marketplace and then resell them at a substantial profit.

The Department of Justice may have been looking to make a splash and send a signal that it is cracking down on crime related to crypto assets. But despite the flashy headlines, this is not an insider trading case. In fact, it’s not clear it should be a criminal case at all.

Picture of different cryptocurrencies

Facts of the Chastain Case

Non-Fungible Tokens, or “NFTs,” are digital assets that are stored on a blockchain, a digital, centralized ledger of transactions. NFTs are unique digital identifier codes that are associated with a particular digital object, such as a piece of digital art. Although digital images can be reproduced, only the owner of the NFT can be said to own the original digital work, which is considered more valuable – sort of like the difference between owning an original Renoir and a print. The Bored Ape Yacht Club, which features thousands of NFTs of cartoon ape characters, is a well-known example.

Chastain worked at OpenSea, the largest online marketplace for the purchase and sale of NFTs. Beginning in May 2021, OpenSea regularly featured particular NFTs at the top of its website’s homepage. Once featured on OpenSea, an NFT usually would rapidly increase in value due to a sudden rise in popularity and demand.

According to the indictment, Chastain was in charge of selecting which NFTs would be featured on OpenSea’s homepage. As OpenSea’s employee, he had an obligation to keep this company information confidential and not exploit it for his own use. But between June and September 2021 he allegedly used this advance knowledge to purchase dozens of NFTs shortly before they were featured on OpenSea. He then sold them at a profit after they were featured and their value rose.

This was not a big-dollar case. The indictment doesn’t specify how much money was involved (which itself is a bit unusual). But in court when he was arraigned, his attorneys claimed that Chastain made only about $65,000 from the scheme.

An interesting aspect of this case is that it appears others in the Crypto-NFT community were the first to figure out what was going on and flag it publicly:

This apparently led OpenSea to fire Chastain and ultimately led to his prosecution. This was possible because what happens on a blockchain is basically public, if you know where to look. (That may have implications for the money laundering charge, as discussed below.)

The Definition of Insider Trading

The very first line of the indictment claims, “This case concerns insider trading in Non-Fungible Tokens or ‘NFTs’ on OpenSea , the largest online marketplace for the purchase and sale of NFTs.” But this is not an insider trading case – at least, not as that term has been used for decades.

Insider trading involves using material, nonpublic information to buy or sell securities in violation of a duty of trust and confidence. Classic or traditional insider trading involves a corporate officer using nonpublic company information to trade shares in her own company, in violation of the duty she owes to her shareholders. Under the “misappropriation theory,” someone who is not a corporate insider but who uses nonpublic information to trade securities in violation of some duty of trust and confidence may also be guilty of insider trading. That duty may arise from trusted relationships such as that between attorney and client or between an employee and an employer.

The Chastain indictment uses some misappropriation theory language that makes the case sound like insider trading. It alleges that Chastain “misappropriated information from his employer, OpenSea, in violation of a duty of trust and confidence that he owed the company, and then used that information to buy and sell the NFTs.”

In an insider trading case the “victim” is the investing public; it’s really a crime against the securities markets. In a true misappropriation theory case the crime is not the breach of a duty (to an employer, in this case) – it’s using the information obtained via that breach to then buy or sell securities. But in this case the government has alleged that the victim is Chastain’s employer, OpenSea. They have charged Chastain with defrauding OpenSea by taking confidential company information and converting it to his own use.

The bull sculpture on Wall Street

NFTs Are Not Securities – and This Isn’t Insider Trading

Insider trading is a species of securities fraud. It’s a crime against the public securities market that damages investor confidence in those markets. As such, it is typically charged as a violation of the Securities Exchange Act of 1934, specifically 15 U.S.C. § 78j and Rule 10b-5 of the Securities Exchange Commission, which prohibit using any manipulative or deceptive device in connection with the purchase or sale of a security. Insider trading may also be charged under a more recent statute, 18 U.S.C. 1348, which also applies to fraud in connection with publicly-traded securities.

The first requirement of these charges is that the fraud was in connection with the purchase or sale of a “security.” But NFTs generally are not considered securities for purposes of these laws.

NFTs obviously are not publicly-listed securities traded on stock exchanges. But other kinds of investments may also qualify as securities under some circumstances. To determine whether an investment is a security, courts apply what is known as the Howey test, named for an early Supreme Court case. Under that test, characteristics of a security include a common enterprise or horizontal connection among various investors whose fortunes are tied to each other, and a vertical connection between investors and the promoters of the investment, with investors depending on profits that will be derived from the efforts of others. Think of the different shareholders investing in a company as the classic example.

Some crypto assets such as cryptocurrencies could potentially qualify as securities — that is currently a matter of considerable debate and uncertainty. But NFTs are more like collectibles or artwork. The closest analogy is buying a painting. If I buy an individual work of art, I am not involved in a common enterprise with any other investors. I may hope that it will increase in value, but I’m not depending on the work of others to make that happen. So when I buy my original Renoir, I am not purchasing a “security” under the Howey test.

Whether the NFTs sold on OpenSea qualify as securities might be a legal issue fought out in some future case (although I think the answer is pretty clear), but it’s not going to be an issue in the Chastain case. For despite calling this an “insider trading” prosecution, the government has not alleged that the NFTs Chastain bought and sold were securities.

If we are not talking about securities, then securities fraud charges — including insider trading — are not an option. And indeed, prosecutors have not employed the statutes that are used to prosecute insider trading. They did not charge Chastain with violating the Securities Exchange Act or other securities fraud statutes. Instead, they charged him with wire fraud.

A final indication that this is not a securities fraud case is the absence of the Securities Exchange Commission. Typically a securities fraud prosecution would involve investigators and agents from the SEC. Here the case is being pursued only by the FBI, working with the DOJ prosecutors.

In short – this is not an insider trading case, despite the headlines and indictment language to the contrary.

Carpenter v. United States

So if this is not an insider trading case, what kind of case is it? Prosecutors have charged Chastain with defrauding his employer, OpenSea, by taking its confidential business information and using that information for his own benefit. The lead charge is good old wire fraud, 18 U.S.C. § 1343 – the prosecutor’s best friend.

There’s no allegation that Chastain harmed any of those who purchased the NFTs after he bought them, or that he owed them any kind of duty. And there’s no evidence that they were actually harmed, since Chastain’s actions didn’t drive up the price and presumably they would have bought the featured NFT regardless of who owned it.

At a court hearing, prosecutors alleged that the landmark 1987 Supreme Court case of Carpenter v. United States supports the wire fraud charge. Carpenter involved a reporter at the Wall Street Journal named R. Foster Winans who wrote a column called “Heard on the Street.” Because of the column’s influence, the stock price of companies he discussed could be expected to rise or fall in response to its publication. Winans entered into a scheme with some stockbrokers to buy and sell stocks before the column was published, using his advance knowledge of the column’s contents. They then profited from changes in the stock prices after the column was published.

Unlike Chastain, Winans actually was prosecuted for insider trading under the misappropriation theory, with the government alleging he had misappropriated the column information in violation of his duty to the Journal. That conviction was upheld by the Second Circuit Court of Appeals, but the Supreme Court evenly divided on the question. When that happens the judgment is affirmed but the case has no value as precedent. (The Supreme Court did not fully embrace the misappropriation theory until ten years later in United States v. O’Hagan.)

But as an alternative theory, prosecutors charged Winans with mail and wire fraud. They alleged he had defrauded the Journal of its intangible business property, in the form of the content of the upcoming column. Unlike with the securities fraud charge, in the mail fraud charge the victim was Winans’ employer, the Journal. His use of the information in the upcoming columns, prosecutors argued, deprived the Journal of its exclusive right to its confidential business property. The Supreme Court upheld this basis of criminal liability.

Image of US Supreme Court, which decided the Bob McDonnell case
United States Supreme Court

Were OpenSea’s Business Plans Property?

On its face, the Chastain case does sound a lot like Carpenter. But prosecutors may face one significant hurdle: proving that the information used by Chastain amounted to “property” for purposes of wire fraud.

The Supreme Court has repeatedly held that fraud requires that the defendant deprived the victim of property. Economic or business interests that do not constitute property cannot form the basis of a fraud charge. The Court’s trend for the past few decades — ever since Carpenter, in fact — has been to limit the reach of the federal fraud statutes by narrowly interpreting this property requirement.

The most recent example was the Court’s 2020 decision in the “Bridgegate” case, Kelly v. United States. There the Court unanimously rejected the government’s theory that the defendants had defrauded the New York/New Jersey Port Authority through a scheme to close traffic lanes on the George Washington Bridge. The Court held that the Port Authority’s power to control access to the bridge, the power of “allocation, exclusion, and control” – although undoubtedly valuable — was not a property interest for purposes of federal fraud laws.

In Carpenter, Winans had argued that the content of the upcoming column was not a property interest and was too intangible to form the basis of a fraud charge. But the Court rejected that claim, holding that the contents of the column amounted to intangible business property, akin to intellectual property such as patents or copyrights.

Prosecutors will argue that Chastain likewise misappropriated the intangible business property of OpenSea. But it’s not clear that argument will fly. A good definition of “property” is a bundle of rights in something that can be possessed, exclusively enjoyed, and transferred to others. That was true of the contents of the “Heard on the Street” column: the Journal owned it exclusively, controlled it, and could have transferred it — by selling the content to another publication, for example. The contents of the column were thus intangible property akin to other intangibles such as patents, which can be exclusively enjoyed or licensed or sold to others.

It’s not clear this is true of OpenSea’s plans for its homepage. The internal plan regarding what NFT to feature is not an asset that could be sold or licensed to someone else. That information may be valuable to OpenSea and it may wish to keep it confidential, but that does not mean it is a property interest for purposes of federal fraud laws. Again, misuse of such information might support an insider trading charge — if we were talking about trading securities. But I’d argue that misuse of internal company plans does not amount to property fraud.

To prove wire fraud, prosecutors will have to prove not merely that Chastain improperly used OpenSea’s private business information, but that he deprived the company of property. I think that will be an uphill battle.

The “Loss of Control” Theory

It’s possible prosecutors intend to rely on the “loss of control” theory to argue that Chastain engaged in fraud. That theory holds that a defendant engages in fraud when he deprives a victim of potentially valuable information that would help the victim decide how to use his assets. The government’s theory might be that Chastain, by deceiving OpenSea and concealing his misuse of its business information, deprived OpenSea of valuable information it otherwise would have use to decide how to control its website, or its business in general.

This “loss of control” theory has been controversial for years. The Second Circuit (where the Southern District of New York is located) has repeatedly approved it, while other circuit courts have disagreed and held it does not amount to fraud. On the final day of its most recent term, the Supreme Court finally granted review in a case, Ciminelli v. United States, where the question presented is whether “loss of control” is a valid fraud theory. In line with the trend over recent decades, I expect the Supreme Court is going to say no. As a result, even if the prosecutors in Chastain were hoping to rely on the theory, that may become impossible.

Picture of $100 bills on a clothesline

The Money Laundering Charge

Prosecutors also charged Chastain with one count of money laundering for allegedly using anonymous OpenSea accounts, rather than the account in his own name, to conceal his purchase and sale of various NFTs. The indictment is pretty vague on this point, but it’s not clear that the money laundering charge will hold up either.

I’ve discussed this issue in connection with other prosecutions, including the Varsity Blues case. Just because you use secret bank accounts or take other sneaky steps to try to conceal what you are doing, that does not constitute money laundering. Money laundering requires that the transactions be in criminal proceeds – funds generated by another criminal activity. In other words, in order to launder money, it needs to be “dirty” in the first place. If Chastain purchased NFTs using his salary or other “clean funds,” that would not be money laundering just because he used an anonymous OpenSea account to do it.

Another crypto-related wrinkle in the money laundering charge is that transactions on a blockchain are public – indeed, that is one of blockchain’s central features. That explains how others in the crypto community were so easily able to see what Chastain was doing and raise questions about it. Given that, does using other blockchain accounts really amount to an effort to conceal transactions sufficient to support a money laundering charge?

It may be that prosecutors will allege that once Chastain bought and sold the first NFTs, all subsequent purchases and sales used the allegedly criminal proceeds of those early transactions. But that would still leave the issue of whether there was really any concealment, given the public nature of blockchain transactions. Again, the indictment is not very specific so it remains to be seen – but as of now, I have my doubts about the money laundering charge as well.

Employee Misconduct Is Not Necessarily Fraud

The indictment alleges that Chastain had a duty to OpenSea to keep the information about featured NFTs confidential and that he violated that duty. But that merely establishes that he was a bad employee. Employee misconduct is not necessarily criminal. As another court of appeals once held, the federal fraud statutes are not supposed to serve as a “draconian personnel regulation.” Chastain may have deserved to lose his job and to be treated with disdain in the crypto community. That doesn’t mean he deserves to go to jail.

I’ll be watching to see how this case unfolds. But if federal prosecutors were trying to show that they are cracking down on crypto-related crime, they picked a pretty lame showcase.

Update: After this post was written, on July 21 the same U.S. Attorney’s Office announced the first “insider trading” case involving cryptocurrency. Prosecutors charged a former Coinbase employee, Ishan Wahi, and two co-defendants with trading on information about which tokens would be listed on Coinbase’s exchange. This case has the same issues discussed above: although prosecutors called it “insider trading,” it really isn’t. Prosecutors have charged wire fraud, not securities fraud, and will face the same hurdles. In Wahi, the SEC has also filed a civil complaint, alleging that the tokens traded do qualify as “securities.” But in the criminal case, just as in Chastain, prosecutors have not charged securities fraud and have not alleged that the cryptocurrencies were securities.

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It’s Not Just the Attack on the Capitol

The “Select Committee to Investigate the January 6th Attack on the United States Capitol” has a slight branding issue: it turns out the Committee’s investigation and hearings into the conspiracy to overturn the election are not primarily about the attack on the Capitol.

The first hearing did focus on the January 6 attack, and was dominated by the riveting and horrifying video montage of footage from that day. But the second hearing focused on the many times Trump was told the election fraud claims were bogus – none of which happened on January 6. The third hearing was about the pressure campaign on vice president Mike Pence, most of which took place prior to January 6. The hearing on June 21 focused on Trump’s efforts to pressure state officials to overturn their election results — all of which happened prior to January 6. The same will be true of other hearings.

This is as it should be. A need to investigate the attack on the Capitol is, of course, what led to the Committee’s creation. But as the Committee’s investigation and hearings have unfolded, it’s become increasingly clear that the assault on the Capitol building was merely the bookend to a much broader conspiracy that unfolded over the weeks between election day and January 6.

In the context of that broader conspiracy, the physical assault on the Capitol, as terrible as it was, was not the most significant event. It was not critical to the conspiracy’s potential success. Even without the assault, the efforts to overturn the election were still potentially criminal and still could have succeeded. And in the long run, the events that took place prior to January 6 are actually more dangerous — because they are easier to repeat, and harder to detect.

Conspiracy street sign

The Language of Conspiracy

The Committee has promised that its hearings will demonstrate a “coordinated, multi-step effort to overturn the 2020 presidential election”. That is the language of conspiracy. And indeed, the most likely criminal charges would be conspiracy to obstruct a Congressional proceeding and conspiracy to defraud the United States.

In civil litigation involving the Committee’s efforts to obtain the emails of former Trump attorney John Eastman, a federal judge in California has already ruled there is evidence that Trump and Eastman likely committed those crimes. The standard in a civil case is far lower, of course, so that ruling alone does not prove a crime was committed. But it’s significant that a federal judge saw the facts that way.

The evidence required to prove these two crimes would be very similar. The central allegation would be that, through a series of actions, the conspirators corruptly sought to prevent or delay the Congressional certification of Joe Biden’s election victory at the joint session of Congress on January 6. Unlike the charge of seditious conspiracy (filed against the white supremacist groups the Proud Boys and Oath Keepers), these charges do not require the government to prove that the conspirators intended to use force to achieve their goals.

Conspiracy to obstruct a Congressional proceeding would be charged under 18 U.S.C. 1512(c)(2) and 1512(k). It’s a twenty-year felony. It requires the government to prove that the defendants conspired to corruptly obstruct, influence, or impede any official proceeding, including a proceeding in Congress. More than 200 of the rioters who actually attacked the Capitol on January 6 have been charged with this crime.

Many of those charged under 1512 have challenged their prosecution on various grounds, including claiming that the joint session of Congress was not an “official proceeding” within the meaning of the statute. About a dozen federal judges in D.C. have rejected that argument, with only one judge agreeing with the defendant and dismissing the charge. That issue is bound for the D.C. Circuit Court of Appeals and perhaps the Supreme Court, but I believe the law is on the government’s side.

A conspiracy to defraud the United States under 18 U.S.C. § 371 requires the government to prove that the defendants conspired to defeat, obstruct, or impede a lawful government function of the United States through corrupt or dishonest means. This was a leading charge in the indictment obtained by special counsel Robert Mueller of the Russian agents who interfered with the 2016 presidential election through social media and other methods. Mueller charged that, through those actions, the defendants conspired to defeat the lawful functions of the State Department, Federal Election Commission, and Justice Department.

One benefit of this charge for prosecutors is that it does not require proof that the defendants’ conduct was otherwise criminal. So, for example, if a court got hung up on the “official proceeding” requirement of 18 U.S.C. § 1512 and decided that statute did not apply, conspiracy to defraud the U.S. under §  371 could still be used to prosecute essentially the same conduct.  

Both of these potential crimes have another significant thing in common: most of the acts done in furtherance of the alleged conspiracies were carried out prior to January 6, by individuals who did not personally storm the Capitol building.

Rep. Liz Cheney
Rep. Liz Cheney (R – Wyo)

The Conspiracy to Overturn the Election

Conspiracies often involve the conspirators following different avenues to try to achieve their overall criminal goal. Different co-conspirators may have different tasks and may take part in different aspects of the conspiracy. Some paths pursued by some conspirators may be more fruitful than others. But all of their efforts are directed toward achieving their ultimate, shared criminal objective

House Committee vice-chair Rep. Liz Cheney (R-Wyo), in her opening statement on June 9, said the hearings would show that “Donald Trump oversaw and coordinated a sophisticated seven-part plan to overturn the presidential election and prevent the transfer of presidential power.” The different parts of that scheme will be the subject of different hearings. They are best viewed not in isolation but as part of a single overall plan, as Rep. Cheney said. And most of them did not depend on an assault on the Capitol. There are many ways to obstruct an official proceeding that do not involve a physical attack on the proceeding’s location.

As Rep. Cheney discussed, the different parts of this plan included:

— Spreading the big lie, by falsely claiming Trump had won the election and that there was widespread voter fraud.

— Corrupting the Department of Justice, by removing senior officials and replacing them with loyalists who would put the power of the Department behind Trump’s false claims of election fraud.

— Pressuring vice president Pence to refuse to count the lawful elector ballots and either send the issue back to state legislatures or simply reject those ballots and declare Trump the winner.

— Pressuring state officials to support false claims of election fraud and change their election results to declare Trump the winner, in states that Biden actually won.

— Sending slates of phony electors for president Trump to Washington, to falsely proclaim that they were the duly constituted electors from their states.

Notably, almost all of these efforts took place prior to January 6 and involved potential co-conspirators who were not on the ground on January 6 and did not take part in the assault on the Capitol.

The Nature of a Conspiracy Charge

Several features of a conspiracy charge make it particularly well-suited for these events. The first is simply that there are multiple individuals involved, pursuing a single criminal goal through multiple different avenues. Conspiracy charges are made to capture such efforts.

In a conspiracy charge, all co-conspirators do not need to be involved in all aspects of the conspiracy. Co-conspirators, as partners in crime, are criminally responsible for each other’s actions. If some were involved in pressuring state officials while others worked on the fake electors scheme or on corrupting the Department of Justice, all conspirators would be responsible as participants in a common enterprise pursued along multiple tracks.

Another key feature of a conspiracy charge is that the conspiracy need not succeed; the wrongful agreement itself is the crime. Hundreds of those involved in storming the Capitol have been charged with crimes that were actually completed – destruction of property, assault on a law enforcement officer, or unlawful entry into restricted areas. But in a conspiracy to prevent the certification of the election through non-violent means, it would make no difference that the certification ultimately was successful.

The proceeding on January 6 was in fact obstructed by the assault; it was delayed for hours as Congress was forced to evacuate the Capitol. But there could be conspiracy charges based on events prior to January 6 that do not include the assault on the Capitol as part of the conspiracy. In such a case, it would not matter that the conspiracy to obstruct the proceeding through other means, such as the phony electors scheme, did not ultimately succeed.

Trump fundraising email
Trump Fundraising E-mail

And Then There’s the Wire Fraud           

Compelling evidence emerged at the June 13 hearing about an entirely different area of potential criminal charges: what Committee member Zoe Lofgren (D-CA) called the “big rip-off”. Trump and his allies allegedly used the phony claims of election fraud to raise more than $250 million from donors for an “election defense fund” that apparently didn’t exist. Instead, money was diverted to Trump’s Political Action Committee and spent on other political projects and donations, including more than $200,000 that went to the Trump Hotel group.

This is an allegation of textbook wire fraud, 18 U.S.C. § 1343. There is a scheme to defraud: fundraising pitches making false claims of election fraud and promising to use donated funds to fight that supposed fraud, and then diversion of the money to other uses by the defendants. And there is the use of wireless transmissions in furtherance of the fraud: the fundraising emails and any electronic payments that were sent in. If I were writing a wire fraud hypothetical for a final exam, I couldn’t do any better.

Trump and his campaign might try to defend by claiming there was “fine print” at the bottom of the fundraising pitches that indicated the money could be used for other purposes. But if the overall design of those pitches is intended to deceive, slipping some fine print in at the bottom won’t prevent it from being considered a fraud. And the pitches also included knowingly false claims about the election being stolen as the reason for raising money, another indicator of fraud.

These additional potential criminal charges, teased by the Committee at the conclusion of the hearing, have no connection to the actual riot at the Capitol. The email solicitations could form the basis for a wire fraud case even if the assault on the Capitol had never taken place.

Bottom Line: It’s About More Than the Assault   

I think it’s useful to place all of the events being covered by these Committee hearings into two distinct categories. There’s the physical assault on the Capitol building on January 6, and there’s all of the non-violent efforts to overturn the election results — most of which took place prior to January 6. Criminal charges could be based on either.

Any potential defendant could be part of one, without being part of the other. The Proud Boys, Oath Keepers, or other rioters who attacked the Capitol (and who are now being prosecuted for that attack) likely had nothing to do with any of the other non-violent efforts to overturn the election. And someone who participated in the phony electors scheme or pressuring state election officials, for example, may have had nothing to do with the riot and may not have anticipated it at all.

We will have to see how any potential criminal charges ultimately shape up. But I could easily see a case alleging a conspiracy to overturn the election results though the various non-violent means that did not include the actual assault on the Capitol as part of that conspiracy. Charges based on the actual assault could proceed on a separate track, as hundreds of such cases already are. And with some defendants — including potentially Trump himself — there may be overlap between the two.

Viewed in this light, the assault on the Capitol is best seen as a tragic side effect of the much larger conspiracy to overturn the election. The attack ended up serving as a useful tool, because it bought the conspirators more time on that day to try to use other means to prevent the certification of Biden’s victory. But it was not essential to the conspiracy, need not have been one of its goals, and need not have been foreseen or planned by the co-conspirators. If the conspirators could have overturned the election peacefully through their various non-violent schemes, they would have done so – and it would still be a crime.

It makes sense for the January 6 Committee to spend much of its time showcasing for the American people the events that took place prior to January 6. The gravest danger to the country actually came not from the riot itself but from the schemes of those who sought to overturn the election through nonviolent means.

Security around the Capitol can be improved. Broken doors and windows can be repaired. Physical injuries can heal. Democracy itself may turn out to be more fragile.

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