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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Coronavirus, Congress, and Insider Trading

There were reports last week of potential insider trading by members of Congress. Several of them sold millions of dollars in stocks as the coronavirus crisis was just beginning to unfold, before the major stock market decline. At the time, they were receiving regular, confidential briefings on the dangers of the virus. Some were publicly downplaying the severity of the problem while they privately unloaded their stock holdings. But although some of these stock trades may have been deplorable, proving they were criminal would likely be an uphill battle.

The Law of Insider Trading

Insider trading is the purchase or sale of securities based on material, nonpublic information, in violation of a duty of trust and confidence. Classic insider trading involves corporate executives or other company insiders trading their own company’s stock based on nonpublic information, in violation of the duty they owe to their shareholders not to exploit company information for their own private gain. A simple example would be a CEO who knows her company is about to be acquired and purchases large amounts of stock in the company before that information becomes public.

Under the much broader misappropriation theory, an individual is liable for insider trading if he trades stock based on material nonpublic information in violation of a duty owed to the source of that information. In the leading Supreme Court misappropriation theory case, United States v. O’Hagan, the defendant was an attorney whose firm represented the acquiring company in an unannounced takeover bid. He bought large quantities of stock and options in the company that was going to be acquired, and made several million dollars once the deal became public. As an outsider, O’Hagan didn’t owe any duty to the shareholders of that company. But he did owe a duty to his own firm and its client not to misappropriate the client’s confidential information for his personal gain. His trades in violation of that duty thus constituted insider trading.

A key in any insider trading case, therefore, is identifying the relevant duty. Trading on material nonpublic information is only insider trading if using that information for a personal benefit violates a duty the trader owes to someone. If you acquire material, nonpublic information through diligent research and hard work, or even by overhearing two corporate insiders talking on an airplane, it’s not insider trading for you to trade based on that information. There must be a violation of a duty.

The Impact of the STOCK Act

Members of Congress, by the nature of their work, necessarily learn a great deal of information that could impact the stock market. In 2012, in response to concerns about Members profiting off such information, Congress passed the Stop Trading on Congressional Knowledge, or STOCK Act. The Act prohibits Members of Congress and their employees from using information learned during the course of their duties for private profit. It directs the Ethics Committees of both Houses of Congress to issue guidance concerning this prohibition. The Act also states that “Members of Congress and employees of Congress are not exempt from the insider trading prohibitions arising under the securities laws.” The Act specifies that Members and Congressional employees owe a duty “arising from a relationship of trust and confidence” to the Congress and to the American people.

This legislative recognition of a duty is significant for insider trading purposes. As just noted, the existence of such a duty is a prerequisite for insider trading liability. The STOCK Act makes it clear that Members of Congress owe a duty of trust and confidence to Congress and the American people not to personally profit from information they learn in the course of their duties. If Members trade stock in a company based on material, nonpublic information learned through their work, they may be liable for insider trading for breaching that duty.

Senator Richard Burr
Senator Richard Burr

The Congressional Trades and Insider Trading

The allegation concerning several Members of Congress is that they received nonpublic information during briefings about the Coronavirus and traded stocks based on that information in anticipation of the coming market crash. Not all such transactions involved stock sales; for example, Senator Kelly Loeffler bought stock in a company that specializes in software that allows people to work from home, and other congressional aides reportedly bought stock in companies such as Clorox, Inc.

To prove insider trading, prosecutors would have to establish that these purchases and sales were based on material, nonpublic information learned during the course of Congressional duties. If they were, then the STOCK act makes clear that such transactions for private gain would violate a duty owed to Congress and the American people and therefore would potentially be insider trading. But there are several factors that suggest establishing insider trading could be challenging.

1) Was the Information Truly Nonpublic?

To evaluate any claims of possible insider trading, it is critical to know exactly what information was relayed at the Congressional briefings. Prosecutors would need to show the briefings included information that was not yet public and that would likely lead those who received the information to conclude the stock market is going to decline. Any investigation into these Congressional trades, criminal or civil, therefore would have to explore what exactly the Members were told in these briefings.

There was a lot of public information already floating around about the coronavirus at the time of the briefings in January and February. Were Members really given information that was not otherwise publicly available? Or did the briefings simply serve to educate the Members and try to get them to focus on the problem, without necessarily relying on material nonpublic information?

The answer may vary depending on the briefing. At least some of the briefings reportedly were classified, which suggests a greater likelihood that they contained information not otherwise publicly available. But as to a more routine, unclassified briefing, it may be that any diligent researcher could have readily come up with the same information that was being given to the Members. And if that’s the case, then acting on that information would not be insider trading.

2) Was the Information Material?

Even if the briefings contained nonpublic information, that information must have been material. Information is material if it is likely to be deemed important to a person deciding whether to buy or sell the stock. One issue here would be that even if some of the information in the briefings was nonpublic, was it so different from what was already available that it would materially influence anyone’s decision to buy or sell? In other words, there was already so much information available that any additional information received in the briefings, even if not otherwise public, may not have made a material difference to a potential trader. Was there actually something disclosed in the briefings that was both nonpublic and so dramatically different from the other available information that it would have tipped the scales on whether to buy or sell?

Another wrinkle when it comes to materiality is that this information likely did not relate to any particular company, or even any particular industry, but to the risks to the country and economy as a whole. Insider trading cases usually involve nonpublic information that relates directly to the stock that was traded. Charging insider trading based on information suggesting that the overall economy in general is going to decline would be unusual. Even if there is information suggesting that the economy as a whole might suffer, how does one prove that information was material to the stock price of any one company? You could try to argue that certain industries seemed more likely to suffer or to profit, and focus on trades based on those industries (such as sales of hotel or airline stocks), but it still could be challenging to prove materiality as to any particular trade.

Once again, what was said at the briefings could be key; for example, if a briefing focused specifically on likely damage to the airline industry, that might support allegations of subsequent insider trading in airline stocks. But if a briefing was focused more on the overall health risks to the country and less on the economic impact, then proving the materiality link to trading stock in any particular company could be much more challenging.

3) Were the Trades Actually Based on the Information Received?

Another possible defense would be that even if there was nonpublic information provided during the briefings, the trades were not based on that information. In the wake of the insider trading allegations, Senator Richard Burr put out a statement claiming his trades were based only on public information, such as reports on CNBC. Burr is claiming, in other words, that even if he received nonpublic information, his trades were based not on that information but on other information that was widely available to the general public.

If there was material, nonpublic information provided at the briefings, then it likely will not be enough for Burr just to claim he relied on other, public information when making the trades. Under SEC Rule 10b5-1, if a person possesses material, nonpublic information at the time of a purchase or sale of a security, there is a presumption that the trade was based on that information. The purchaser can rebut that presumption, but only by showing that there was a pre-existing, written plan or order to sell the stocks that predates the receipt of the nonpublic information. Absent such a pre-existing order, a Member or staffer will be presumed to have relied upon any material nonpublic information received when making a trade.

A related issue will be whether the Member or other individual who received the information actually ordered the trades in question. Senator Kelly Loeffler, for example, has claimed on Twitter that she does not make decisions about her stock trades and that those decisions are made by third-party advisors without her input. Senator Diane Feinstein has claimed that her stocks are held in a blind trust and that this particular trade was made in her husband’s account, and so any trades were made without her knowledge or participation. If trues, these would be defenses to any claim of insider trading.

One question raised by Senator Loeffler’s defense is whether she had any communications with those “third party advisors” where she shared information learned during the briefings. She may not make the decisions herself, but if she passed along material, nonpublic information and her advisors traded on that information then she could still be liable for insider trading as a “tipper” or for aiding and abetting. The same would be true if she passed the information to her husband, who happens to be Chairman of the New York Stock Exchange, and he then relied on that information to trade or to direct others to trade on their behalf.

Representative Chris Collins

The Case of Representative Chris Collins

These allegations have led some to compare these Members of Congress to Representative Chris Collins, who was recently sentenced to 26 months in prison for insider trading. But the cases have almost nothing in common. Collins served on the board of a pharmaceutical company and sold stock in that company after receiving confidential information from the board chairman that a major drug trial had failed. The Collins case differs from these current allegations in two important respects. First, the inside information Collins gained was not as a result of his work on Capitol Hill. His status as a Congressman was irrelevant to his insider trading case, as was the STOCK Act. Collins could have been just any board member, trading on confidential information received from the chairman. And second, the information Collins received was specific to the one company in whose stock he subsequently traded – it wasn’t information about a potential overall market decline.

The Appropriate Remedy

These stock trades deserve to be investigated. Some certainly seem to violate the spirit of the STOCK Act. But given the issues described above, it seems unlikely that any will result in a criminal case. And a criminal remedy is not necessarily the answer; there are many possible consequences for these actions besides a criminal prosecution. The SEC may pursue civil insider trading charges, where the penalties may include fines and disgorging of profits. Other shareholders in companies that were dumped may sue for civil stock fraud. The Ethics Committees can explore the allegations and impose sanctions as well; Senator Burr, for example, has already requested an Ethic Committee investigation of his own stock trades. Members of Congress could face calls to resign, as some already have. And of course, voters have the ultimate political sanction at the ballot box for any offenders who run for re-election.

One good outcome would be for this scandal to lead to reforms that include a requirement that every Member of Congress hold their stocks and other assets in blind trust, with absolutely no control over investment decisions. Until that is the norm, allegations like this will continue to arise and there will always be suspicions that some Members are using the power of their office unfairly to line their own pockets. Such conduct may not always be criminal, but it’s always wrong.