The Rise Of Fraudulent Insolvencies Of NFT Projects: What To Do When You Are Rug Pulled? – Fin Tech

NFTs are non-fungible tokens that can be held and transferred on
blockchains. Alongside the growth of NFTs as a digital asset class
has also come the increase of misconduct-based insolvencies of NFT
projects. “Rug pulls” are crypto-scams perpetuated
against investors in NFT projects, where creators offer a
collection of NFTs for sale but ultimately abscond with
investors’ digital tokens and/or funds.¹ As reported
by Chainalysis, in 2021, over US$2.5-billion worth of
cryptocurrency assets were stolen or defrauded from victims
worldwide via rug pulls.²

While there are various types of rug pulls, one of the most
common is a “pump and dump” scheme. Generally speaking,
fraudsters can create an altcoin or target a small-cap token that
is then boosted over social media; once the coin or token in
question is purchased, tokens/coins are then dumped onto the market
– often leaving investors with bags of worthless product.
While the Department of Justice publicly announced enforcement
actions charging individuals with crypto-fraud offences in the
United States in 2022,³ it remains unclear whether
Canadian police are actively pursuing perpetrators of rug pulls
interjurisdictionally.

This article aims to summarize recent North American
jurisprudence and news regarding recent rug pulls and concludes
with steps that creditors or investors can take to recoup their
funds if they have experienced fraud or misconduct due to a rug
pull.

North American Jurisprudence

(a) Classification

Most North American litigation involving NFT projects still
emerges from the United States, and a significant amount of NFT
litigation continues to revolve around classification issues of the
digital assets themselves. As an example, a May 2021 class action
suit was filed by investors who had purchased Moments NFTs
(“Moments“).⁴ In the lawsuit
within the Southern District of New York, the plaintiffs alleged
that a Vancouver-based Web3 company, Dapper Labs, violated federal
American securities laws in neglecting to register Moments with the
U.S. Securities and Exchange Commission prior to sale. Dapper Labs
responded by filing a motion to dismiss on the grounds that Moments
– which capture NBA highlights – are not securities but
rather tradable goods along the lines of digital basketball
cards.

Judge Victor Marrero held that the plaintiffs adequately alleged
that Moments constitute investment contracts under the four-prong
test first articulated in SEC v. W.J. Howey
Co.,⁵ which indicates a given transaction comprises
an investment contract if it involves: (a) an investment of money;
(b) a common enterprise; and (c) a reasonable expectation of
profits that are (d) derived from efforts of others. Resultingly,
the ongoing complaint was allowed to proceed and the motion to
dismiss by Dapper Labs was denied, although Dapper Labs has since
issued a public statement on Twitter that Moments are “simply
modernized trading cards, not financial
instruments”⁶ and that they “look forward to
vigorously defending our position in Court as the case
continues.”⁷

The eventual holding on the ongoing Dapper Labs case is likely
to trigger regulatory scrutiny against centralized companies in the
NFT space. Crypto-commentators have indicated that, while
regulators may continue to use the Howey Test prongs on projects
that pose the risk of being classified as securities, the ultimate
ruling will be a significant step in providing regulatory clarity
for all NFT projects, whether public or private.⁸

(b) Rug Pulls

Growing numbers of defrauded investors have initiated civil
litigation over rug pulls throughout the United States in 2023,
although the growth of jurisprudence in Canada remains limited.
American consumer groups have further put some high-profile
celebrities, including Gwyneth Paltrow, Tom Brady and others, on
public watch for “promoting NFTs without appropriate
disclosures.”⁹

Two key cases from 2023 in the United States and Canada that are
likely to shape the scope of future rug pull litigation are
highlighted below.

United States

Influencer Logan Paul currently faces a rug pull class action
over his involvement with CryptoZoo NFTs, which were originally
announced and marketed beginning in September of 2021. The class
action lawsuit, filed in the District Court of the Western District
of Texas in Holland v. CryptoZoo Inc. et al.,¹⁰
alleges that while CryptoZoo was marketed as an NFT-based game and
billed as “an autonomous ecosystem” that would enable
virtual “ZooKeepers” to buy, sell and trade exotic
animals on a blockchain, in reality:¹¹

This action seeks redress from
Defendants for their fraudulently promoting and selling products
that did not function as advertised, failing to support the
CryptoZoo project, and manipulating the digital currency.
Defendants operated this fraudulent venture to exploit and steal
from Plaintiff and other customers who trusted Mr. Paul’s false
representations. As a result, Defendants defrauded Plaintiff and
thousands of other consumers, and unjustly enriched themselves by
profiting off Plaintiff and others without delivering on their
promises.

While Paul had earlier tweeted that he intended to create a
US$1.3-million reward program for “disappointed
players,”¹² the filing of the class action in
February 2023 by investors alleges that “Logan Paul and
Defendants knew or should have known that they were falsely
advertising a non-functional product and that consumers would be
deceived by their false representations.”¹³ A
ruling on CryptoZoo, if not settled out of court, is likely to
symbolize a significant movement forward in the growth of
crypto-litigation surrounding rug pulls.

Canada

In December of 2021, a Quebec plaintiff sought both prohibitive
and mandatory orders of provisional injunction seeking to be
recognized as holding 25 per cent of the shares of a partnership in
an NFT project to have access to all relevant business information
and to benefit from the profits generated therefrom.¹⁴
This relief was denied.

In a disappointing comment made by the Quebec court, it was held
that as cryptocurrency wallets are virtual and “not controlled
or placed in any particular jurisdiction, which would make such an
order impossible to execute,”¹⁵ the court itself
could not order that the defendants “keep the control over
cryptocurrency wallets in the province of
Quebec.”¹⁶ Litigants should be well aware that this
remark continues a long line of comments by North American courts,
where rulings are made by the judiciary itself, that they are not
certain that even courts hold personal jurisdiction over the
defendants due to the virtual nature of the digital wallets in
question.¹⁷ Plaintiffs should be well-reminded that
legal practitioners must advise courts about the properties of the
NFTs in question to show their link to the jurisdiction in
question, as otherwise procedural challenges due to miseducation
may stymie their ability to seek legal relief and redress.

Conclusion and Next Steps

There are certain warning signs that investors should be aware
of when placing funds in crypto-assets or crypto-asset project such
as NFTs or tokens: (a) poor fundraising goals or endpoints; (b)
limited background information on founders; and (c) purchased
followers or fabricated websites, along with disproportionate
yields. Despite these signs, it is very easy for investors to
accidentally fall victim to fraud.

If you have been defrauded in a rug pull, the following next
steps can be taken:

1. Legal contact by a lawyer should be made with stablecoin or
   exchange providers to freeze hacks or stolen funds, rather than
   immediately jumping to civil litigation. In light of the slow
   recovery rates and limited jurisprudence involving rug pulls,
   attempts should first be made to reach out to crypto-asset
   providers rather than the judicial system in order to recover
   misconduct-based insolvency NFT funds. Often, crypto-asset
   providers and/or exchanges are able to freeze funds through
   processes that are external to traditional North American legal
   recovery systems.




2. If legal action is initiated through the Canadian legal system,
   plaintiffs should contemplate using traditional insolvency tools
   such as the appointment of receivers, if available, rather than
   simple civil recovery methods. There have been successful cases of
   the return of coins to estates on outstanding claims of unjust
   enrichment, conversion and fraudulent transfer. As an example, in
   the American case of Rasmussen,¹⁸ a
   court-appointed receiver successfully sued defendants for the
   recovery of funds stemming from a cryptocurrency payment made by an
   entity, AriseBank, for the purchase of a non-existent bank.




3. If insolvency litigation tools are unavailable, litigants
   should turn to options such as injunctive relief, as well as
   consider the involvement of litigation funders. Furthermore, when
   seeking the assistance of a Canadian or American court in
   recovering funds through a civil process, steps should initially be
   taken to trace missing or stolen crypto-assets through the use of
   independent crypto-tracing firms. It is likely that courts will
   require reports from litigants to prove the movement of funds,
   especially if mixers or tumblers are involved, and given the
   jurisdictional issues discussed above.

Footnotes

1 “What Are Crypto Rug Pulls?”,
Worldcoin (14 December 2022), online: (https://worldcoin.org/articles/rug-pulls#toc-0).