NFT Rug Pull Legality

On January 11, one of the biggest NFT rug pulls to date was pulled off without a flaw – the developers (“devs”) of the Big Daddy Ape Club NFT collection failed to mint the 2,222 promised apes, and instead took off with 9,136 SOL, or around $1.3 million at the time. The NFT tokens were never created, and the Twitter, Discord, and official website were all deleted without warning. The Big Daddy Ape Club investors were the victims of a rug pull.

So, what is a rug pull?

A rug pull scam is a malicious, intentional act in which crypto devs create, or seem to create, a project, promise various things to a community that they never intend to fulfill, and end up either abandoning the project without warning with the project funds or sell off the pre-mined holdings. Think of it as the crypto version of a small cap stock pump and dump. What do these scams all have in common? The single goal of taking an investor’s funds.

“Soft” rug pull strategies are another form of rug pull that are are being utilized by devs. Soft rug pulls lead investors on for longer periods of time in order to appear more legitimate. As prices start to increase, the devs slowly start to sell tokens under the radar in an attempt to avoid the mayhem that comes with a typical “hard” rug pull.

Currently, no regulators exist that can authenticate whether or not a project is legitimate. The decentralized nature of crypto currency exchanges puts law enforcement in a gray area and prevents agencies from enforcing legal actions. Further, a majority of NFT projects are created by devs that have maintained anonymity, making it even harder to vet their identities and their intentions.

Even though various media outlets and investors are spreading light on this heinous and fraudulent act, in 2021 alone, DeFi rug pulls raked in roughly $2.8 billion. As these scams quickly become all too common, it begs the question “is this legal?

What about the SEC?

In order for the US Securities and Exchange Commission (SEC) to get involved, NFTs would need to be considered a security. A security is defined as an “(1) investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) to be derived from the efforts of others.” SEC v. Howey Co., 328 U.S. 293 (1946). This is known as the Howey Test.

The SEC has recently started looking into what it would take to regulate NFTs as if they were securities. Hester Pierce, the SEC member spearheading this conversation, has centered her discussions around fractionalization. Think, for example, of a piece of property where the ownership is divided into 100 parts. Each part is then minted onto an NFT and sold for a certain price. The owner can then either build on the piece of property, or sell it for profit. This NFT then creates a way for smaller investors that normally wouldn’t have access to an investment of this kind to suddenly be able to invest in a piece of property.

If the Howey test is applied to the property example above, we get the 1) sale of a share of property that (2) will be owned by a group of investors who (3) plan to make a profit from either selling the property or creating a space of value on that property, which can only happen if the property (4) is maintained.

Britain, unlike the US, has already started to regulate NFTs. In the case of AA v Persons Unknown [2019] EWHC 3556 (Comm), the High Court of England, opined that crypto assets can be treated as traditional property. Therefore, the civil remedies typically available to personal property cases are applicable to cases involving NFTs.

For the US, it’s not a matter of if legal regulation will happen, but when. For now, investors are strongly urged to always undertake proper due diligence to make sure their hard earned money is being invested into a legitimate project.

Don’t get caught with your pants down.

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