How to stay out of the eye of the Department of Justice and the Securities and Exchange Commission when dealing with NFTs

Bloomberg Tax

The Department of Justice, the Securities and Exchange Commission, and other regulators are seeking non-fungible tokens.

Earlier this year, the Justice Department indicted Nathaniel Chastain, a former NFT trading desk employee, in the first NFT insider trading case. The SEC has also been busy, reportedly issuing subpoenas to NFT creators and cryptocurrency exchanges to determine if NFTs are being used to raise money like traditional securities.

While many companies are understandably interested in learning and using Web3, the Department of Justice has made it clear, “Web3 is not a law-free zone.”

Whether a company wants to use NFT for transactions or to promote products and engage users, it must take the time to understand (and mitigate) the various regulatory risks associated with NFT.

The Department of Justice and other regulators are committed to identifying and prosecuting illegal NFT-related activities. One of the recurring themes in these efforts has been whether NFTs are securities, and if so, when.

NFTs are, by definition, not interchangeable (i.e., unique). Because NFTs are not fungible, the Department of Justice and the SEC may have difficulty establishing that NFTs are subject to federal securities regulation.

Is it safety?

To date, neither the Department of Justice nor the SEC has directly addressed the question of whether an NFT is a security, and if so, when. But that doesn’t stop the Justice Department from prosecuting illegal activities historically linked to securities fraud.

In the Chastain case, the Justice Department evaded this issue by choosing to prosecute using the wire fraud charge instead of the securities laws traditionally used in insider trading cases.

But companies won’t be able to circumvent securities laws by simply claiming that a digital asset is an NFT. As SEC Chairman Gary Gensler said, the SEC is “not concerned with labels, but with the economic realities of the supply.”

It was on this basis that government securities regulators took enforcement action. Despite company claims to the contrary, NFTs issued were considered securities and subject to regulation.

While the SEC itself has not taken any enforcement action on NFTs, they are certainly not far off. The SEC’s announcement in May to expand its Crypto Assets and Cyber ​​Unit highlights its focus on NFTs.

Additionally, earlier this year, the SEC reportedly issued a subpoena seeking information on how NFT creators and crypto exchanges use NFTs, including fractional NFTs. These FNFTs, which are “fractions” of the same NFT, are more likely to be considered securities because, unlike NFTs, they are neither unique nor fungible.

Illegal activity

The Justice Department may also focus on prosecution of the use (and failure to prevent the use) of NFTs to launder proceeds from illegal activities. Attackers often use expensive real estate and art to launder money due to their high value, and NFTs can act as a similar conduit for large amounts of money. For example, The First 5,000 Days, an NFT created by artist Beeple, sold for $69 million in 2021.

Combined with the relative anonymity of NFT transfers on the blockchain, NFTs can be an effective mechanism to “clean up” illegally obtained funds.

The Justice Department can also take action against platforms facilitating NFT transactions for failing to comply with anti-money laundering laws. The government has already suggested that such platforms may be subject to anti-money laundering laws if NFTs are a “value substitute for currency” and there is increasing pressure for legislation or regulation that explicitly includes these platforms within their purview.

For example, Attorney General Merrick Garland is pushing for Congress to amend anti-money laundering laws to apply unequivocally to platforms that sell NFTs. The government is also considering whether the AML laws applicable to those involved in the “antiquities trade” could apply to those involved in NFT purchases, sales and transfers.

Stay out of trouble

Before diving into Web3 exploring NFTs, companies should consider taking certain steps to try and stay out of the eye of the Justice Department and other regulators.

First, it would be wise for companies to carefully evaluate their compliance program to ensure that it meets the Department of Justice expectations as outlined in the Assessment of Corporate Compliance Programs.

Further, to avoid inadvertently issuing a security in the form of an NFT, businesses using NFTs (and digital assets in general) should consider whether the asset has characteristics that might make it a security. For example, a company may avoid actions that could affect the market price of NFTs and prohibit fractionation of NFTs.

Finally, companies involved in facilitating NFT transactions must implement Know Your Customer policies and controls to ensure sufficient due diligence. This includes verification of sanctions and monitoring of transactions, carried out at registration and on an ongoing basis.

The Department of Justice and other regulators are focused on NFTs, and more NFT-related prosecutions and enforcement actions are imminent. Taking action now will help avoid problems in the future.

This article does not necessarily reflect the views of Bloomberg Industry Group, Inc., publisher of Bloomberg Law and Bloomberg Tax, or their respective owners.

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Author information

Andrea Gordon is an advisor to 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, focusing on national, domestic and international investigations, tax disputes, and cybersecurity and privacy law.

Adam Pollet is a partner at Eversheds Sutherland in the Washington DC office. It defends financial institutions, broker-dealers, investment advisors, and individuals during regulatory investigations and enforcement issues involving the SEC, FINRA, and government securities regulators.

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