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Non Fungible Tokens: a legal perspective — NFT Crime and Compliance

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United Kingdom

In part one of this series, we outlined some of the reasons behind the rapidly growing popularity of non-fungible tokens (NFTs), and discussed issues surrounding ownership—both of the NFT itself, as well as the associated digital asset. Part two focused on IP infringement, and part three explored commercial and data privacy issues.

In this final part, Chris Eastham (Technology & Data) and Will Glover (Commercial Crime) look at the compliance aspects of NFTs, what some of the offences might be for ill-informed ventures, and whether victims of NFT crime can make any effective use of the criminal courts to seek justice.

The sad reality is that valuable assets and high profile creators will attract rogue actors to the NFT marketplace. The marketplace also attracts enthusiastic legitimate business-people, whose business ventures 'innocently' wade into areas of potential criminality. The two main areas of wrongdoing are said to be 'wash trading', and good old-fashioned money laundering[1].

Anti-Money Laundering Regulations

Of particular interest to legitimate businesses wanting to get into the crypto market are the requirements to comply with laws seeking to prevent money laundering. A recent US Treasury report concluded that NFTs are particularly susceptible to money laundering, stating that "no single platform operates the same way or has the same standards or due diligence protocols". The report also notes that, "art auction houses or galleries, may not have the technical understanding of distributed ledger technology required to practice effective customer identification and verification in this space"[2].

For those doing business in the UK, the particular rules are the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017, as amended (the AML Regulations). They cover, among other entities, "Art Market Participants", "Cryptoasset exchange providers", and "custodian wallet providers". If a business falls within the definition of those entities then they must comply with the myriad requirements of the AML Regulations in any event (regardless of whether they trade in NFTs). The requirements include registration with the Financial Conduct Authority (FCA), and satisfying the fit and proper person test.

The application of the AML Regulations to cryptoasset exchange providers and wallet providers was introduced following the European Union's 5th Anti Money Laundering Directive. However, a particular challenge for businesses operating in the UK is the wide implementation wording that was used in the definition of the former, which includes not only those exchanging or making arrangements for the exchange of cryptoassets for fiat currency (or vice versa), but also those exchanging or making arrangements for the exchange of cryptoassets. This means that the wording of the AML Regulations is wide enough to capture the exchange of NFTs for crypto currency (such as Bitcoin).

It is a criminal offence to contravene any one of a wide range of relevant requirements under the AML Regulations, and businesses should take care not to fall foul of these complex and nuanced rules.

Wash Trading—A Dirty Practice

'Wash trading' is where one person artificially inflates the value of an item by trading it multiple times with themselves (or another in a conspiracy) to give the appearance of artificial demand. Think back to those bygone eBay auctions where you always wondered whether the person selling that one final trading card missing from your collection had set up another account to artificially bid up the value. In that example, replace the trading card with an NFT, or anything else for that matter.

It's been referred to as a "murky legal area" which is prohibited in the case of conventional securities and futures in the US[3]. It is interesting that it seems little comparison has been made between the exercise of wash trading and 'shill bidding' practices on auction sites. For those new to the term, a 'shill' (or 'stooge') is someone that publicly helps someone else without disclosing their relationship—so shill bidding is where the shill bids on the seller's item to artificially increase its price, desirability, or search standing.

In the past, individuals have been prosecuted successfully for shill bidding on eBay, based on offences contrary to the Business Protection from Misleading Marketing Regulations 2008 (business-to-business) and Consumer Protection from Unfair Trading Regulations 2008 (business-to-consumer). Depending on the precise facts, sellers might similarly infringe these regulations in a case involving NFT wash trading.

Taking a different tack, there is also the possibility that wash trading could constitute a criminal fraud. Where someone has knowingly artificially inflated the value—for example giving an item a price that is £1,000 more because of artificial trades—that could amount to a false representation. The exercise could also amount to a conspiracy to defraud, if done with others. The legal analysis doesn't appear to be materially different from a scammer who makes a false representation about the value of an item to an unwitting purchaser (e.g., coloured diamonds, carbon credits, or investment wines which often feature in Ponzi scheme cases). The main difference being that the seller here has artificially stacked up the price as opposed to simply making a statement about the value.

The tricky aspect for the prosecution lies in tying the ultimate price paid by the unwitting bona fide purchaser, to the actions of the seller in artificially inflating the price, on a step-by-step basis. An alleged fraudster might argue that each individual step is legitimate (in the sense that each purchase is not false), whilst the prosecutor would seek a finding that the overall conduct or enterprise with the overinflated price at the end is criminal.

Any scenario would have to be considered carefully on the facts to determine whether an offence has been committed and could be pursued. Moreover, depending where different elements of the potential offences have been committed or participated in, there may also be jurisdictional hurdles to overcome.

Can I 'get nicked'?

The main areas of potential exposure for 'criminally uneducated businesses' in the NFT space are breaches of the AML Regulations discussed above, criminal property offences under the Proceeds of Crime Act 2002 ("POCA"), and offences under the Financial Services and Markets Act 2000 ("FSMA"). There are also new rules coming in soon in Europe, called The Markets in Crypto Assets Regulation ("MiCA")

Proceeds of Crime Act 2002

Beyond non-compliance with the AML Regulations, a business involved with NFT trading could commit a substantive criminal property (i.e., money laundering) offence. We see the most likely provisions of POCA to be infringed as being:

  • s.328             being concerned in an arrangement which they know or suspect facilitates the acquisition, retention, use or control of criminal property;
  • s.330/331      failure to disclose suspicions, if the individual operates in the regulated sector (i.e., failure to make suspicious activity reports); or,
  • s. 333A          tipping off offences, if they operate in the regulated sector.

Financial Services and Markets Act 2000

In its 2019 guidance on crypto assets, the FCA defines unregulated tokens as those "that do not provide rights or obligations akin to specified investments (like shares, debt securities and e-money)". Although the FCA has made clear that 'direct investments' in NFTs are not regulated[4], that is a generic statement and there is much debate in the marketplace about whether NFTs are regulated or not. In reality it will depend on whether in any given scenario the NFT in question has characteristics making it similar or akin to a traditional security. In the Financial Action Task Force (FATF) report on this issue, the distinction as to whether an NFT ought to be regulated comes down to whether an NFT is truly a collectible, or whether it is a payment or investment instrument[5]. Ultimately, if an entity that trades in NFTs is captured by FSMA and does not have permission from the FCA, an offence could be committed under s.23 of the Act.

Individuals trading in NFTs may also fall foul of the promotion offence under s.21 of FSMA if they are not careful as to their status. This doesn't just apply to UK based individuals, but also affects communications from outside the UK if they are capable of having an effect in the UK. The FCA has issued the following warning, "It is a legal requirement that firms make clear in their promotions which activities are, and are not, regulated, especially when highlighting their FCA authorised status. For example, an authorised firm may decide to offer access to unregulated cryptoassets (such as exchange tokens, like Bitcoin or Ether). The firm must not, in any way, communicate that their authorisation extends to those unregulated cryptoassets, and communication should be transparent to ensure consumers are aware which activities the firm is authorised for."

The Markets in Crypto Assets Regulation

This new law introduces another thorny area to be aware of for those operating in the EU. It was recently approved for implementation by the end of 2023, and Europe has set out a complete regulatory framework for crypto asset regulation. The extent to which the UK will mirror the requirements of MiCA remain to be seen however, and the Law Commission is currently consulting on various issues relating to the treatment of crypto assets by the UK courts.

Someone's pinched my NFT!

A relatively well known case in the crypto space is AA v Persons Unknown [2019] EWHC 3556, in which it was established that cryptocurrencies could amount to property in English law. This was recently extended to NFTs in Lavinia Deborah Osbourne v (1) Persons Unknown and (2) Ozone Networks Inc trading as Opensea [2022] EWHC 1021 (Comm). In those cases it was decided that a claimant could benefit from the proprietary remedies available to victims of cryptocurrency fraud.

While these were civil actions, for something to be stolen according to s.1 of the Theft Act 1968, it needs to amount to property in law[6]. Until this decision (and perhaps still, until the issue is finally decided), it was arguable that someone whose NFT was misappropriated had not fallen victim to a theft because they had not lost 'property'.

There are lots of other possible offences which might apply where NFTs have been unlawfully taken or accessed. Here are some of the more noteworthy contenders:

  • Conspiracy to defraud (aka 'The Prosecutor's Friend');
  • Other fraud offences (e.g., Fraud Act 2006);
  • s.1 Computer Misuse Act 1990;
  • Intellectual Property Offences (e.g., s.107 of the Copyright, Designs and Patents Act 1988); and
  • Consumer Protection from Unfair Trading Regulations 2008.

Can crypto criminals be brought to justice?

The anonymity of trades on the blockchain represents a potential problem for criminal prosecutions and has resulted in claims by some that criminal recovery is ineffective. However, the blockchain itself will make it easier to trace the criminality and wrongdoer. That coupled with the use of powers under Part 8 of POCA means that prosecutors and investigators may be able to more readily obtain information from NFT platforms, crypto wallet custodians, or the parties to NFT transactions to identify possible suspects. Once individuals are identified, further investigations can be carried out and charges brought if appropriate.

Sometimes investigating authorities (e.g., a police force) may consider that crypto related complaints are really civil issues; particularly where the parties are not 'vulnerable' in the more traditional sense. However, through the making of appropriate representations, authorities may be persuaded to take on instances of NFT crime. Even if the individual can't be identified by name, it's still possible to bring a civil action—NFTs were recently used to serve documents on a crypto wallet in a High Court Action in the case of D’Aloia v. Persons Unknown and Binance Holdings Limited & Others.

If the State does not take on a prosecution, there remains the possibility of a private prosecution. An order can still be obtained by a private prosecutor to restrain assets once an information has been laid. Assistance can also be sought from the authorities by a private prosecutor. In the event of a conviction, a private prosecutor can also seek confiscation and compensation from the guilty party.

There are potential benefits to pursuing a private prosecution (e.g., costs recoverable by private prosecutors and the deterrent impact of a successful prosecution) but there are also difficulties (such as extra-territorial issues, extradition, the criminal standard for conviction, and the importance of the timeliness of any restraint application). The importance of these issues will vary from case to case and so early advice on the best option is an absolute must.

Closing Thoughts

The prevalence of criminality in the area of crypto assets is well known. Something less often considered is whether businesses are falling foul of relevant provisions. If someone is concerned about their own unwitting conduct, or is a possible victim of crypto crime, it is important to seek clear advice in relation to any concerns and the best way forward at the earliest possible stage.
 
The issues associated with NFTs, blockchain, distributed ledger technology (DLT), and digital assets are cross discipline—from regulation and technology licensing, to privacy and IP. Our leading technology law team has the expertise and experience to help you achieve your strategic objectives when it comes to emerging technologies.


[1] For those looking for further detail, the Chainalysis Crypto Crime Report of 2022 has a whole chapter dedicated to NFTs and crime.
[3] Chainalysis Crypto Crime Report of 2022, page 34.
[6] Per s. 4(1) "Property" includes money and all other property, real or personal, including things in action and other intangible property".
 

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