Scams explained: What is a rug pull? Are they illegal?

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At the beginning of March, 2022, the US Department of Justice (DOJ) has indicted Frostie’s founders Ethan Nguyen (“Frostie”) and Andre Llacuna (“heyandre”) in what has been dubbed the Federal Bureau of Investigation’s first NFT “rug pull” investigation.

As well as advertising themselves as a “cool, delicious, and unique” collection of 8,888 NFTs, the Frosties project also promised investors raffles, merchandise, and a “special fund to ensure their long-term sustainability.” However, they did not fulfill their promises. 

As the result of a two-month investigation, prosecutors in the Southern District of New York arrested and charged Nguyen, 20, and Llacuna, 20, for “promising investors incredible benefits with the Frosties NFTs. However, when it sold out, they then pulled the rug out from under the investors, almost immediately shutting down the website and transferring the money,” according to the press release.

Scams involving cryptocurrency are not new. Investors and regulators have been dealing with these scams since 2017. In spite of their serious consequences, rug pulls are just the latest form of fraud. NFT rug pulls accounted for 37 percent of all cryptocurrency scam revenue in 2021, according to Chainalysis. This represents a 1 percent increase over 2020. 

Since the number of users continues to increase, lawmakers, regulators, and members of the crypto and NFT communities must remain especially cautious and vigilant. It is essential to understand NFT, crypto rug pulls, and how to safeguard yourself if you want to join NFT’s ecosystem. The following information is provided as a guide. 

The basics of crypto scams: What is a “Rug Pull?”.”

Similar to a pump and dump scheme, a “rug pull” is a fraudulent act in which crypto developers entice investors, only to abandon the project by either (1) taking off with the project funds or (2) selling off their pre-mined assets with the intent of draining investors’ funds.

Generally, when prices reach a certain level, the developers will start withdrawing funds from the ecosystem and disappear entirely. Nguyen and Llacuna, for example, are alleged to have shut down the project website, closed the Discord server, and transferred all the proceeds to various digital wallets after generating over $1 million in cryptocurrency from the project’s community. Investors were unable to contact developers and were never provided with anything they had been promised. 

Both Nguyen and Llacuna now face a sentence of 20 years in prison. 

Sadly, this is a common scenario and certainly not the first scam involving cryptocurrency. Despite this, while this is not the first “rug pull” to target new investors and veterans alike in the NFT sector, the DOJ’s recent bust of Nguyen and Llacuna is a first. Consequently, the event certainly raises a number of new questions about the legal landscape. For a full understanding of this event’s legal significance, it is necessary to dig a little deeper into the nature of this specific type of crypto and NFT scam.

What are the legal ramifications of crypto and NFT rug pulls?

First of all, should NFTs, because of their nascent status in the fintech space, be subject to the same rules as other types of investments? 

In short, the answer is no. 

In a statement issued in March, Special Agent-in-Charge Thomas Fattorusso commented, “NFTs represent a new era for financial investments, but the same rules apply to an investment in a NFT or a real estate development.” “You can’t solicit funds for a business opportunity, abandon that business and abscond with money investors provided you.”

Considering the horrific ramifications that victims ultimately face in any potential scenario, it is important to inquire whether rug pulls are illegal. The answer to this question depends on the form the rug pull takes during the time that it occurs as lawyers expand their legal knowledge regarding NFTs. 

How do rug pulls differ from one another?

Hard rug pulls, which involve a project’s founder peddling the project as a means of defrauding investors, are illegal. The smart contract in this instance contains conditions within its code that are designed to deceive investors in order to steal funds. In most cases, that code is prima facie evidence that it is meant to mislead investors and steal their funds. In addition, it is used to lock investors into assets that have no real direction or purpose. 

Soft rug pulls, on the other hand, aren’t illegal, however, they are considered highly unethical in nature. Smart contracts differ from hard rug pulls in that the code is not intended to defraud investors, but does not eliminate the possibility of investor theft or deceit. 

Generally, this occurs when founders or their teams rapidly dispose of assets, thus devaluing the token and exploiting the profit created by investors buying the cryptocurrency. In the case of a crypto project that promises to donate funds, but instead chooses to keep the funds (for whatever reason).

It is still possible for you to be criminally liable

It is clear from the DOJ’s recent NFT bust, that the Justice Department does not play around. Earlier this year, in February, the Justice Department announced it had appointed Eun Young Choi to lead the National Cryptocurrency Enforcement Team (NCET). 

A press release stated that the NCET was formed to ensure the department handled the growing challenge posed by the criminal misuse of cryptocurrencies and digital assets. Members of the NCET include attorneys from across the department, as well as experienced prosecutors in cryptocurrency, cybercrime, money laundering, and forfeiture.

Choi’s responsibilities as NCET Director include identifying, investigating, supporting, and pursuing departmental cases involving the criminal use of digital assets, including virtual currency exchanges, mixing and tumbling services, infrastructure providers, and other entities (NFT projects) that enable the misuse of cryptocurrency and related technologies. 

However, despite the fact that there is no official law governing NFTs, there are still ways in which individuals can be held criminally liable and prosecuted, specifically for fraud, money laundering, and of course, conspiracy to commit fraud and money laundering. 

It was announced a month after Choi’s appointment and the establishment of NCET that the DOJ had seized nearly $3.5 billion in cryptocurrency, following the arrest of Illya Lichtenstein and Heather Morgan for laundering it. 

Many individuals believe that the federal government has inadequate resources to deal with criminal acts of this magnitude using this new form of technology, but Frosties should serve as a clear warning to all that regulators are paying close attention to NFTs, while the government is still capable of exerting its resources to unravel complex transactions and to help unmask perpetrators attempting to remain anonymous. 

And don’t forget The Silk Road. 

The SEC are watching closely

A market now valued at over $40 billion, the size of the NFT market has nearly doubled from a value of $25 billion last year, encompassing everything from artworks and collectibles to virtual assets and real estate. 

It is not surprising that the Securities and Exchange Commission (SEC) has reportedly started discussions with NFT creators and certain NFT marketplaces in order to determine if NFTs are being utilized in a way that violates U.S. securities laws. 

In accordance with the 1946 landmark U.S. The Supreme Court held in the Howie case that transactions that qualify as “investment contracts” are subject to U.S. securities laws if they involve the (1) investment of money into a (2) common enterprise in which a (3) reasonable expectation of profits is to be derived from the efforts of others.

While the SEC continues its investigation into digital assets, Chairman Gary Gensler has made clear that he, along with the agency, will place greater emphasis on regulating crypto markets. This has left the entire crypto community in a state of confusion over how the SEC will approach its first attempts at regulation.

Be skeptical of NFT issuers’ claims

Ultimately, before you invest in any cryptocurrency or NFT, make sure you have spoken with a lawyer, or at least have one available to you. There is nothing wrong with having another pair of eyes that can help you stay alert, cautious, and diligent.

Additionally, when considering different NFT projects to invest in, take into account whether the project has a “story” or a “heart” that serves to provide meaning, direction, and a clear roadmap of where it is going. If you do not have these safeguards, then you are simply placing yourself in a situation where you could lose everything.

As digital assets, particularly NFTs, have grown in popularity, lawyers may have been forced to broaden their ethical responsibilities in order to adequately and zealously represent their clients. Of course, this requires that they be at least familiar with the space enough to be able to have those fundamental conversations with their clients about digital assets.

Andrew Rossow is an attorney and journalist who focuses on fintech and intellectual property law.

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