Regulation and enforcement in the cryptocurrency space are hot topics, with the debate centered around the complex issue of whether to classify digital assets as securities, commodities, or a separate asset class entirely.
In the middle of this debate, the Department of Justice (DOJ) has sent a message — the classification does not matter for its purposes. In recent prosecutions, DOJ has used the wire fraud statute, 18 U.S.C. § 1343, a law with origins dating back to the 1800s, to bring innovative cases in the cryptocurrency space that do not depend on how a digital asset is classified.
My previous article in February 2022 highlighted how DOJ could seek to use the wire fraud statute to prosecute rug pulls (i.e., take the money and run schemes), insider trading, and the market manipulation of digital assets. (See McGinley, “Expect indictments in the NFT space soon,” Reuters Legal News (Feb. 4, 2022)).
Since then, DOJ has used wire fraud to prosecute the first two rug pulls involving NFTs and to prosecute two digital asset insider trading cases. DOJ has not recently used wire fraud in a large-scale market manipulation case, but it is likely to be a next area of focus, given public reports of market manipulation and spoofing (creating orders with the intent to cancel) by crypto whales, who are individuals or entities that own substantial amounts of a particular cryptocurrency.
The wire fraud statute in brief.
The wire fraud statute is based on the nearly identical mail fraud statute, which was enacted in 1872 to combat fraud committed through the mail. The wire fraud statute expanded the law beyond the mails to include the telephone, and now all forms of telecommunication including email, text messaging and social media. In general terms, the wire fraud statute prohibits using a wire communication to obtain money or property through a scheme to defraud, which is often accomplished through misrepresentations or false promises.
The statute is adaptable; it is not limited by subject matter. Prosecutors have applied it to insider trading schemes, spoofing, and other forms of market manipulation. It is a powerful tool for prosecutors. For this reason, Judge Jed Rakoff famously quipped that to prosecutors the mail and wire fraud statutes are “our Stradivarius, our Colt 45, our Louisville Slugger, our Cuisinart — and our true love.” (Jed S. Rakoff, “The Federal Mail Fraud Statute (Part 1),” 8 Duq. L. Rev. 771, 771 (1980)). DOJ’s recent cases in the crypto space only prove Judge Rakoff’s point.
- Rug pull cases
In the first half of 2022, DOJ charged two innovative NFT rug pull cases using the wire fraud statute, both of which are still pending. First, in March 2022, the U.S. Attorney’s Office for the Southern District of New York (SDNY) in U.S. v. Nguyen charged the first fraud case involving NFTs. SDNY alleged that the creators of the Frosties NFT collection committed a $1.1 million rug pull by falsely promising purchasers that in addition to cartoon-like images, they would receive perks, such as giveaways and access to a metaverse game.
Second, in June 2022, the DOJ Fraud Section in U.S. v. Tuan charged the second NFT rug pull against the creator of the “Baller Ape” NFT project, alleging a $2.6 million rug pull. The allegations in that case are even more egregious: the creators did not provide anything to purchasers, not even images.
In neither case did the DOJ allege that the NFTs at issue were securities or commodities, as the classification of NFTs was immaterial to the wire fraud charges. DOJ charged a basic theory of wire fraud — that purchasers of these NFTs did not receive what they were promised.
- Insider trading cases
DOJ has adopted a similar approach in the insider trading space, charging cases that do not hinge on complexity of the underlying asset. In June 2022, SDNY charged the first ever digital asset insider trading case, against Nathanial Chastain, a former OpenSea employee.
The Indictment in U.S. v. Chastain alleges that Chastain had advance knowledge of which NFTs would be featured on OpenSea’s homepage, which generally leads to an increase in the NFT’s price. Chastain purchased the NFTs before they were listed and sold them after listing for a profit, reportedly around $67,000.
A month later in U.S. v. Wahi, SDNY charged another digital asset insider trading case — this time against a former Coinbase employee and two others for engaging in a similar scheme. The allegation is that Ishan Wahi, a Coinbase employee, knew which tokens the exchange would list and tipped this information to his brother and friend, who traded on the information for a $1.6 million profit.
In both cases, DOJ charged wire fraud, not securities fraud, the typical charge in insider trading cases. Although this theory will likely be challenged in court, and the defendants have pleaded not guilty, the use of wire fraud to prosecute insider trading has a long history, dating back to the 1987 Supreme Court case Carpenter v. United States, (484 U.S. 19 (1987). That case involved a Wall Street Journal columnist, who wrote about new stocks in his column. This information was considered confidential business information belonging to the newspaper. The columnist misappropriated this information by giving advance notice of the stocks he would feature to his friends at a brokerage firm, who used the information to trade the stocks. DOJ relied on Carpenter because the misappropriation was strikingly similar to the alleged misappropriation in Chastain and Wahi.
Relying on wire fraud provides additional advantages for DOJ. First, DOJ may avoid burdensome and complicated litigation about whether the underlying assets are securities. Second, it allows the DOJ to act unilaterally. In the typical securities fraud case, for example, the DOJ and SEC work in parallel and bring simultaneous cases. While there are benefits to this coordination, it also takes time. When the DOJ solely charges wire fraud, there is less coordination because the SEC cannot charge wire fraud. Rather, the SEC can only bring enforcement actions when the underlying asset is a security.
- Disclosure/misrepresentation cases
In both NFT cases, DOJ focused on representations made to purchasers of the respective NFTs. While these were not large-scale frauds, they underscore DOJ’s focus on the accuracy of the statements and disclosures defendants made to purchasers in digital assets — regardless of the identity of the underlying asset.
Going forward, we can expect DOJ to focus on larger disclosure issues, likely at the corporate level. Crypto companies communicate with the public frequently, over various forms of social media. Companies often respond in real time to market events. While communicating quickly and frequently with the public has commercial benefits, it can also lead to inaccuracies. DOJ has already used wire fraud to prosecute alleged misrepresentations made over social media in other contexts (seeU.S. v. Milton, S.D.N.Y. 2021), and it may seek to do so as well in the crypto space.
- Larger insider trading cases
The first digital asset insider trading case charged one defendant for reportedly profiting under $100,000. The second one, just one month later, charged three defendants for approximately $1.5 million in profits. This trend in complexity and dollar value will likely increase, especially given reports of larger insider trading problems in this space. (See Foldy and Ostroff, “Crypto Might Have an Insider Trading Problem,” Wall Street Journal (May 21, 2022)).
Insider cases in a particular industry often start relatively small and involve those closest to the source of information. Over time, they evolve to focus on downstream tippees — that is, individuals at trading firms a few steps removed from the information, but capable of placing larger trades. I would expect DOJ to focus next on investigating insider trading by large market participants and crypto focused trading firms.
- Market manipulation cases
Finally, we can likely expect the DOJ to use the wire fraud statute to prosecute market manipulation in the digital asset space. The media has long reported on suspected manipulative trading practices in the cryptocurrency markets, including wash trading, and spoofing. (See, e.g., “In Crypto, Market Manipulation Remains a Problem,” PYMTS.com (Aug. 1, 2022)).
As to spoofing, the practice of crypto whales using buy and sell “walls” has attracted attention. These “walls” are essentially price points created by placing large volumes of buy or sell orders, with the idea of artificially inflating the price of a token to sell high, or decreasing a token’s value to create a buying opportunity.
In 2018, DOJ apparently investigated price manipulation in the crypto markets. (Robinson and Schoenberg, “U.S. Launches Criminal Probe into Bitcoin Price Manipulation,” Bloomberg (May 24, 2018)). Given the rise in prominence of crypto in our economy since 2018, it is only logical that DOJ will tighten its focus on these practices.
Although the DOJ’s results in using wire fraud to prosecute spoofing cases have been mixed (and beyond the scope of this article), the DOJ recently prevailed in a spoofing case involving precious metal futures before the 7th U.S. Circuit Court of Appeals using a wire fraud theory. (See, e.g.,United States v. Chanu, (7th Cir. July 6, 2022)). This success will likely encourage DOJ to apply wire fraud to crypto market manipulation.
As crypto becomes mainstream, prosecutors have responded with one of DOJ’s oldest tools — wire fraud. In the first half of 2022, DOJ was actively prosecuting cases under the wire fraud statute, and we can expect that trend to continue and expand into other areas of financial fraud traditionally prosecuted by the DOJ, including corporate disclosure and market manipulation cases.
August 23, 2022 Published by Reuters News.