Trial of former OpenSea product manager could broaden regulators’ definition of ‘insider trading’

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Former OpenSea product manager Nathaniel Chastain’s trial has been almost a year in the making, and its outcome could be important not just for future NFT-related charges but also insider trading charges outside of financial markets.

The trial, which starts on Monday in New York, deals with two charges against Chastain for wire fraud and money laundering, each of which carries a maximum penalty of 20 years in prison. Federal prosecutors allege that the former OpenSea employee used confidential information about which NFTs were going to be featured on the marketplace’s homepage to personally profit. Chastain has pleaded not guilty.

Chastain’s attorney declined to comment. The Department of Justice did not immediately respond to a request for comment.

In a statement announcing Chastain’s arrest and indictment, the Department of Justice labeled the case against him the “First Ever Digital Asset Insider Trading Scheme.” And yet, Chastain has not been charged with “insider trading,” according to its legal definition.

According to past interpretations of insider trading, covered under Section 10(b) of the Securities and Exchange Act of 1934, a person would have to either purchase or sell a “security” for an offense to be considered insider trading. But NFTs have not been defined explicitly as securities, based on the “Howey Test,” through rules by the Securities and Exchange Commission. The agency’s enforcement actions have also been mostly limited to cryptocurrencies and related companies.

The issue of whether NFTs are securities probably won’t be discussed during the trial—the presiding judge, Jesse Furman, has made it clear in court documents that the only issues to be weighed by the jury are the crimes of which Chastain has been accused. And yet, the case could set a precedent for applying the term “insider trading” to issues that have nothing to do with financial markets or securities.

The defense is arguing that this could make breaches of employment contracts criminally punishable by the federal government, as Chastain’s actions allegedly defrauded his employer, OpenSea. Meanwhile, prosecutors argue that this is a classic example of fraud.

With Chastain’s indictment, the DOJ has reinforced its strength and flexibility in bringing charges related to digital assets like NFTs and cryptocurrencies, whereas the SEC in some cases has struggled to make headway because its charge is to enforce securities law.

Wire fraud charges have been used in several cases involving non-securities, including that of Elizabeth Holmes and former Coinbase employee Ishan Wahi, who pleaded guilty to two counts earlier this year in an insider trading case involving two other individuals, including his brother, Nikhil Wahi, who was sentenced to 10 months in prison earlier this year.

By using the wire fraud charge, prosecutors can sidestep the issue of whether NFTs are securities entirely, although the term insider trading can still be used at trial after a motion by Chastain to preclude use of the term was denied last week.

“Jurors are unlikely to be familiar with the technical legal meaning of the term,” Furman added in a court document filed last week. The judge also said he would brief the jury on the nuances of the term being used to clear up any confusion over the public being harmed versus OpenSea, as prosecutors allege, and insider trading being the actual charge presented.

For the wire fraud charge, prosecutors will still have to tackle the question of whether Chastain deprived OpenSea “of money or property,” which means they’ll have to prove that information about which NFTs were going to be listed on the marketplace’s homepage were property.

Chastain and his lawyers last year asked Furman to dismiss the case, in part because of the property question and also because they argued that “absent any connection to the financial markets…” prosecutors did not meet the standard for charging him with “insider trading.” Furman rejected this argument in an opinion in October, stating that Chastain was not charged with insider trading.

Although NFTs are a new kind of technology, Furman granted a motion by prosecutors that would stop Chastain from arguing that the case is “novel or unprecedented.” Furman said that the government’s theory of prosecution is identical to that in Carpenter v. United States, in which a Wall Street Journal reporter was found guilty of mail and wire fraud, as well as securities violations, for sending information about company stocks featured in a column to two brokers who directly profited.

If Chastain is found guilty, the case could provide precedent for prosecutors to point to in other cases of alleged NFT “front-running,” and yet, the question of NFTs as possible securities will likely hinge on a different case, according to digital asset lawyer Max Dilendorf of New York City-based Dilendorf Law.

The class action lawsuit Friel v. Dapper Labs, which a judge allowed to go forward earlier this year, centers around the question of whether the NFT company’s sports-related “Moments” digital collectibles are unregistered securities. Plaintiff Jeeun Friel alleges that the Moments NFTs are securities under the Howey Test that should have been registered with the SEC. The judge found that the plaintiffs argued this well enough for the case to go forward.

Key to the judge’s decision to let the case proceed was the outsized control Dapper Labs had over the Flow blockchain on which the NFTs are hosted, as well as the secondary marketplace on which Moments can be sold. If Dapper Labs were to go out of business, the court argued, Moments would be worth next to nothing. The matter will be decided in court.

Although it appears that regulators have mostly left the NFT industry alone, unlike many of its crypto cousins, that’s not exactly correct, according to Dilendorf. SEC Chair Gary Gensler has made it clear that he believes all digital assets save for Bitcoin are securities, and this should have the NFT industry looking closely at Chastain’s case and the Dapper Labs lawsuit, he said.

“Following [Gensler’s] logic, they can analyze any crypto project, including NFTs, under the Howey Test,” Dilendorf added, “and make a determination of whether or not the offering of those digital arts, whatever they are, could be could be viewed as an investment contract.”

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