The Pirate of OpenSea

We tend to think of piracy today as the unauthorized distribution of copyrighted material and not so much as the activity of bandanaed marauders. But OpenSea’s former head of product, @natechastain, reminded us this past week that the exploitative version of piracy lives on, because the Sea is lucrative. It was discovered that Nate had been buying and selling NFTs based on advance information he acquired in his position as the head of product at OpenSea, the world’s largest marketplace of digital assets. It appears that Nate was purchasing pieces at low prices prior to featuring them on the homepage, and then selling them for higher prices in the new market.

Timeline

Here’s what happened:

• On September 14, Twitter user @ZuwuTV tweets at OpenSea, questioning the timing of Nate’s transactions: 

• On September 14, Twitter user @btcinchina tweets an image of transaction data showing addresses and the improper profits allegedly made by Nate:

• On September 15, Devin Finzer, co-founder and CEO of OpenSea, publishes a tweet linking to a blog post in which OpenSea comments on the wrongdoing of an employee and its adoption of new employee policies in response:

It looks like Nate may have done a bad thing and subsequently resigned when asked to. Equally interesting is the rhetoric that emerged out of the NFT community’s outrage. Some blasted Nate for “insider trading”—a term that refers to a technical, legal test—while others claimed Nate’s actions were “front-running.” Here’s the thing: Nate’s actions might be found by a court of competent jurisdiction to be one or both of those things, but it’s not likely given the fact that NFTs currently exist in an in-between grey area yet to come under serious regulatory scrutiny. 

Legal Theories

Dozens, if not hundreds, of influencers and media outlets have repeated the claims that Nate’s actions constituted insider trading since he was not supposed to use information he received from his day job for personal gain. Our society generally doesn’t like insider trading for a few reasons: it gives one party an unfair advantage, it misallocates value and it undermines confidence in markets. But were Nate’s actions technically “insider trading”?

The concept of insider trading has evolved as a creature of case law that interprets the applicability of the anti-fraud and related provisions of the Securities Exchange Act of 1934. Practically, that means that there’s no single provision you can look up to define insider trading. Instead, courts have determined that certain elements must be present to support a finding: at its simplest, a person (i) traded securities (ii) while in possession of material non-public information (iii) in breach of a fiduciary duty. Did Nate trade? Yes, but did he trade securities? Probably not (under current laws). The U.S. Securities and Exchange Commission is still in the process of figuring out whether and which cryptocurrencies are “securities.” Gary Gensler, Chair of the SEC, recently stated on September 14 the following: “Right now, large parts of the field of crypto are sitting astride of — not operating within — regulatory frameworks that protect investors and consumers, guard against illicit activity, and ensure for financial stability.” As an offshoot of cryptocurrencies, NFTs are several steps behind and not currently designated as “securities.”

Was Nate in possession of material non-public information? Without getting into the weeds of “materiality,” probably. As the head of product, Nate determined which projects would be featured and had specific knowledge of timing that was not publicly known. Finally, was Nate in breach of a fiduciary duty? Said differently, was Nate a fiduciary to creators and users of OpenSea? Maybe, but maybe not. Regardless, NFTs haven’t been categorized as securities, so the test likely fails at the first step. Front-running (trading a security based on non-public information regarding future movement in the price of that security) is probably not applicable for similar reasons. There are, however, broader legal theories under which someone in Nate’s shoes could face liability, including wire fraud, which criminalizes fraudulent acts committed through the use of interstate wire communications (like a blockchain over the Internet).

The Open Sea

The NFTs available on OpenSea exist behind the transparencies of an immutable blockchain. While it has been speculated that other collectibles markets (for example, sports cards and trading card games, particularly Magic: The Gathering) have been plagued by unfair transactions based on “insider” information for years, those markets trade tangible objects through the traditional system of opaque exchanges. The community-led investigation into Nate’s actions demonstrates that the blockchain worked as it was designed to. Traceable transaction data can be used to sniff out abuses of asymmetrical knowledge.

OpenSea, like every other company, is run by an imperfect management team and imperfect employees, some of whom may make mistakes. But OpenSea has already taken commendable steps. Concurrent with its acknowledgement of Nate’s actions, OpenSea launched an investigation and adopted new trading policies for its employees: “OpenSea team members may not buy or sell from collections or creators while we are featuring or promoting them (e.g. on our home page); and OpenSea team members are prohibited from using confidential information to purchase or sell any NFTs, whether available on the OpenSea platform or not.” 

But there’s still the problem of figureheads and loud finger-pointers within the community who have an outsized influence on how the narrative of events like this develop. Some of them have called for the decentralization of OpenSea, as if decentralization is the answer to every problem. OpenSea already has through the blockchain everything it needs to address this and similar problems that will emerge in the future. Unfortunately, the damage is done. The uproar and wide media coverage has left NFTs in a worse place and will serve as an embarrassing moment that lawmakers can point to when arguing that this nascent industry needs safeguards like the ones in place for equity markets.

Not legal advice.