What Are Rug Pulls? Are They A Common NFT Scam Or Crypto Crime?
In the first NFT “rug pulls” raid in March 2022, the U.S. Department of Justice (DOJ) charged Frosties founders Ethan Nguyen (“Frostie”) and Andre Llacuna (“heyandre”) with conspiracy to commit fraud and conspiracy to commit money laundering.
The Frosties and their developers were revealed due to the Department of Justice’s $1,100,000 NFT raid. The ice cream-themed business promised investors raffles, products, and a “special fund to ensure the Frosties’ longevity.” They should have carried out their commitments. However, are our Frosties the worst non-alcoholic frozen dessert of all time? It’s just one of many that have prompted people to question if NFTs are bogus. According to a press release, after a two-month investigation, prosecutors in the Southern District of New York arrested and charged Nguyen, 20, and Llacuna, 20, with “promising investors the benefits of the Frosties NFTs, but when it sold out…pulling the rug out from under the victims, almost immediately closing the website and transferring the money.”
Frauds involving cryptocurrencies are not new. At the earliest, they have tormented regulators and investors since 2017. Rug pulls are the most modern kind of fraud, yet they have had significant consequences. Chainalysis says that non-fungible token (NFT) scams caused more than $2.8 billion in losses in 2021. 37% of all cryptocurrency scam revenues and a 1% increase from 2020. As the number of users keeps growing, the number of “rug pulls” has gone up. This has caused lawmakers, regulators, and people in the crypto and NFT communities to be very careful and aware of new projects. To engage in the NFT ecosystem, you must understand what NFT and crypto rug pulls are and how to protect yourself. Here’s all you need to know.
The Crypto Scams 101 defines a “Rug Pull” as follows:
Similar to a “pump and dump” scheme, a “rug pull” is a malicious scheme in which crypto developers try to get early investors and then abandon the project by either (1) fleeing with the project’s capital or (2) selling their pre-mined shares to get rid of all the money from investors.
When the price exceeds a certain point, the creators usually take their money out of the ecosystem and disappear. According to the criminal complaint, once the community collected over $1 million in bitcoin, Nguyen and Llacuna pulled down the project’s website, shut down the Discord server, and shifted all sales proceeds to other digital wallets. Those who invested in the initiative could not interact with its authors and never got the promised rewards.
NFT Rug pulls planning move to Aptos pic.twitter.com/ZThohrhwHh
— erikpadilla.eth🎃🦇👻 (@erikpadillagon) October 25, 2022
Nguyen and Llacuna now face up to twenty years in prison.
To appreciate the legal significance of this episode, we must go a little more into the nature of this specific crypto and NFT fraud scheme. This is not the first crypto scam of this kind, as it is an all-too-common occurrence. Even if this is not the first “rug pull” to target novice and experienced investors in the NFT business, the recent DOJ bust against Nguyen and Llacuna is a first. As a result, the incident indeed raises several brand-new concerns about the legal environment. But U.S. court systems responded with full force to the Frosties NFT rug, marking too many the beginning of crypto and NFTs’ image as the Wild West of the Internet.
As a result, new difficulties in the legal environment arose. With high-profile arrests of other thieves in the crypto and NFT industries, the Frosties case may stop people from trying to copy the scam. However, even though federal agents are monitoring Web3 for illicit activities more closely than ever before, our laws may need to catch up. To understand the legal importance of this event, we need to learn more about this type of crypto and NFT fraud.
Are cryptocurrencies and NFT rug pulls illegal?
The first question is whether NFTs, due to their relative youth in the fintech industry, are governed by different rules than other types of investments.
The answer is “no.” In March, Special Agent-in-Charge Thomas Fattorusso said, “NFTs represent a new era in financial investments, but the same restrictions apply to investments in NFTs and real estate projects.” You can only ask investors for money for a business idea, leave the company, and take the money with you. The second thing to consider is whether rug pulling should be illegal, given how bad it is for victims in every possible situation. As legal knowledge of NFTs grows, most lawyers will agree that the answer to this question depends on the form of the rug pull as it happens.
What are the types of rug pulls?
A “hard rug pull” occurs when a product’s developer uses coding to abuse the project to deceive investors fraudulently. In this case, the statements in the smart contract code are meant to trick investors into stealing money. Since the code often locks investors into assets with no real direction or purpose, it is clear that the goal was to scam and steal money from investors.
On the other hand, soft rug pulls are not “illegal” per se but are usually seen as immoral and frowned upon within the NFT sector. People feared a future Azuki rug pull after hearing that the designer of Azuki had abandoned past projects. What then differentiates a gentle rug pull from a hard rug pull? Instead of making codes for intelligent contracts to trick or steal from investors, the plan to cheat or steal from investors still stands.
Most of the time, this happens when the creators and their employees quickly sell their assets, which lowers the token’s value and lets them profit from the profit made by investors who buy the currency. One example is a cryptocurrency project that says it will give out money but keeps the money for whatever reason.
You are still liable for criminal acts.
The Justice Department recently showed its seriousness with the Frosties NFT raid. In February, the Department of Justice announced Eun Young Choi’s nomination as the team’s first director (NCET). According to the news release, the NCET was created to ensure that the department deals with the problem of the illegal use of cryptocurrencies and digital assets. The NCET comprises lawyers from all over the department, including prosecutors who are experts in cybercrime, cryptocurrencies, money laundering, and forfeiture.
Choi will help find, investigate, support, and go after cases involving the illegal use of digital assets. He will focus on virtual currency exchanges, mixing and tumbling services, infrastructure providers, and other entities (NFT projects) that make it easy to use cryptocurrency and related technologies to commit or help commit crimes. Even though there is no explicit law governing NFTs rug pulls, individuals may still be held legally accountable and punished for fraud, money laundering, and conspiracy to commit fraud.
The Frosties should serve as a warning to all that regulators are paying close attention to NFTs. A month after hiring Choi and starting NCET, the Department of Justice (DOJ) said it had recovered nearly $3.5 billion in cryptocurrencies after Illya Lichtenstein and Heather Morgan were arrested on money laundering charges. At the same time, the federal government can still use its resources to unravel complicated transactions and help find criminals who try to hide their identities. That is in contrast to what many people think: the federal government can’t handle crimes of this size that involve this new type of technology.
Regulators and the SEC are monitoring it closely.
The market for non-fungible tokens has almost quadrupled in size, exceeding last year’s estimate of $25 billion, and now includes artwork, collectibles, gaming assets, and virtual real estate. So, it shouldn’t be a surprise that the Securities and Exchange Commission (SEC) has reportedly started talking to NFT designers and specific NFT marketplaces that sell them to find out if NFTs rug pulls are being used to break U.S. securities law. The SEC’s Web3 has provided the SEC with new difficulties despite the agency’s prior market-regulatory expertise.
According to the precedent-setting 1946 U.S. Supreme Court decision Howie, transactions that qualify as “investment contracts” are subject to U.S. securities laws if they involve (1) the investment of money in a joint venture with a (2) reasonable expectation of profits from the efforts of others; and (3) a reasonable expectation of gains from the efforts of others.
As the SEC continues to look into digital assets to learn more about them, Chairman Gary Gensler has clarified that he and the agency will focus more on regulating cryptocurrencies which has left the cryptocurrency community wondering how the SEC will go about making rules for the first time.
Then, should you be afraid? No, unless you want to commit fraud yourself. It would be good for the NFT industry and regulatory bodies like the SEC to work together. A big part of the SEC’s work to regulate cryptocurrencies and NFTs starts with gathering information about how the major market players run their businesses. First, the Bored Ape Yacht Club made news in October 2022 when word circulated that the SEC was investigating it. In contrast to fraudsters like Ethan Nguyen and Andre Llacuna, the BAYC welcomed this news openly and fully cooperated with the SEC’s investigation.
Consider NFT issuers’ statements with a grain of salt.
Having a second pair of eyes is always beneficial to help you stay watchful, diligent, and attentive. Ultimately, before investing in any cryptocurrency or NFT rug pulls the project, you should consult with a lawyer or at least have one ready. Ensure that the NFT project you’re considering investing in has a “story” or “heart” that gives it a purpose, direction, and a clear path for the future. Without them, you’re putting your money into something you don’t know and putting yourself at risk of losing everything. Lawyers may have expanded their ethical duties to represent clients professionally and zealously because digital assets, especially NFTs, are becoming more common, which means they need to know enough about digital assets to have these critical conversations with their clients.