The Rise of Fraudulent Insolvencies of NFT Projects: What to Do When You Are Rug Pulled?

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.

If you are caught in a cryptocurrency fraud or NFT rug pull and require further insolvency litigation assistance, please contact members of our Financial Services or Litigation teams.

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