’Rug Pull’: New York Senator Introduces Bill To Criminalise Crypto Fraud

May 9, 2022
A New York senator has introduced a bill that would criminalise so-called "rug pulls" and other types of crypto fraud.

A New York senator has introduced a bill that would criminalise so-called "rug pulls" and other types of crypto fraud.

In April, Senator Kevin Thomas (D-NY) introduced a bill that stipulates criminal penalties for offences such as “virtual token fraud”, “private key fraud”, and “fraudulent failure to disclose interest in virtual tokens”.

But the key section of the bill, which appears to be the first time that such terminology has been used in US legislation, is that which relates to crypto “rug pulls”.

Traditionally known as “pump and dump” schemes, a rug pull is when the holders of an asset inflate its value using deceptive means, before selling it to unsuspecting buyers.

But, according to the bill, a crypto rug pull will be defined not by fraudulent intent but simply by the percentage of the total supply of a token owned by its developer and how quickly they sell it to the public.

Specifically, the bill would make it a criminal offence for a developer who owns 10 percent or more of a class of tokens to sell 10 percent or more of the total supply within a five-year period.

Although not a perfect comparison, it is notable that this rule is significantly more restrictive than that applied to shares in publicly traded companies, and this has not gone unnoticed among crypto developers and investors.

Vlad Totia, a blockchain research analyst, told VIXIO that the rule is “counterintuitive” and would unfairly penalise developers.

“I don’t think it would solve the problem of bad founders, and also, you don't really have this ban for people who hold shares in companies,” he said.

“If you start a company and then it's listed on the Nasdaq, you're not going to be forced to sell less than 10 percent of everything you have over five years.”

In the US, before a company goes public, it typically enters into a lock-up agreement with its underwriter to ensure that insiders cannot cash out their shares immediately after the IPO.

In New York, the typical lock-up period for an IPO on the New York Stock Exchange (NYSE) is 180 days, and on the Nasdaq it is 90 to 180 days.

However, some stocks go public on the Nasdaq with no lock-up period, using a mechanism known as a direct listing.

In April 2021, Coinbase became the first crypto exchange to go public after completing a direct listing on the Nasdaq.

This allowed founder and CEO Brian Armstrong to start selling his shares immediately, including three sales worth a combined $291m on the stock’s first day of trading.

Other Coinbase executives and beneficial owners, some of whom held more than 10 percent of the company’s total shares, also cashed out early.

So quickly did Coinbase insiders divest themselves of the stock that, by February this year, only 1.83 percent of the company’s total shares were still held by insiders.

To put that in perspective, the five-year lock-up period proposed by Senator Thomas is more than ten times the average lock-up period imposed by a New York IPO.

And as Totia pointed out, even if a new crypto-asset developer were to follow the rules outlined in the bill, it would not necessarily prevent fraudulent activity.

On the contrary, the longer lock-up period may actually help “pump and dump” schemes to take place, by inflating the value of the token for a longer period of time.

“It won't stop rug pulls,” he said. “The only thing it will do is make the founders’ tokens stay frozen, and the price of the token will be artificially kept up, whether the project is good or bad.”

Fraud, private keys and failure to declare

The other offences outlined in the bill are arguably less controversial and can be seen as crypto versions of existing laws designed to protect investors from fraud.

“Virtual token fraud”, for example, is defined as the act of deceptively or fraudulently inducing others to buy, sell, exchange, transfer, offer, store or destroy a virtual token.

“Private key fraud” is defined as the act of, knowingly or otherwise, using, obtaining or disclosing another person’s private key to a virtual token without their affirmative consent.

Both of these provisions can be applied to any person, group or company, but the final offence, as with the rug pull offence, is reserved specifically for developers.

“Fraudulent failure to disclose interest in virtual tokens” is defined as the act of not publicly and conspicuously disclosing the number of tokens owned by the developer of a class of virtual tokens.

The bill adds that such information, to stay within the law, must be published on the “landing page” of the developer’s “primary website”.

Objections, penalties and jurisdiction

While the bill attempts to offer protections to crypto investors, critics will no doubt take issue with its definition of “fraudulent” and “deceptive”, which could arguably be applied to the marketing of most crypto-assets.

Under US federal law, securities fraud is defined as the act of knowingly misrepresenting a material fact, in a way that leads to material losses for those who acted on the misrepresentation.

The difficulty of applying this definition to crypto, as with other new technologies, is that the substance and purpose of crypto is still so ill-defined, and so hotly debated, that it is difficult deduce when a person is making knowingly false claims about a crypto-asset.

This is complicated even more so by the fact that, in order for a current holder of a crypto-asset to profit from it as an investment, they must necessarily induce others to buy from them at a higher price.

These objections might also strike a chord with crypto’s more traditional detractors, such as Rabi Sankar, deputy governor of the Reserve Bank of India, who said in February that all crypto-assets are essentially Ponzi schemes.

“As a store of value, cryptocurrencies like bitcoin have given impressive returns so far, but so did tulips in 17th century Netherlands,” he said.

“A bitcoin is akin to a zero-coupon perpetual: it’s like you paid money to buy a bond which pays no interest and which will never pay back the principal.

“A bond with similar cash flows would be valued at zero, which, in fact, can be argued as the fundamental value of a cryptocurrency.”

The difficulty of determining “fundamental value” is perhaps what makes crypto such prime territory for fraud, as, in practice, the real value of a crypto-asset is whatever its holders believe it to be.

This explains why the practice of hyping up a new coin, while simultaneously using one’s followers as exit liquidity, is so common among crypto influencers.

2021 was a boom year for this type of fraud, as influencers large and small flocked to the explosive bull market offered by crypto and its many new coins.

Kim Kardashian and boxer Floyd Mayweather, for example, are currently being sued in the US for allegedly defrauding investors in the now-collapsed EthereumMax token.

On a smaller scale, Scott Melker, a crypto podcaster and host of the "Wall of All Streets" show, is accused of repeatedly using his followers as exit liquidity for tokens that he acquired through private auctions - a common practice before a new coin goes public.

Out of the 19,323 crypto-assets currently listed on Coinmarketcap.com, it is likely that the vast majority will have been offered for sale to residents in the state of New York.

But when a new crypto-asset is ultimately revealed as having been “fraudulently” or “deceptively” marketed, how far will New York go to pursue those who helped inflate its price and induce others to buy?

For those found guilty of any of the offences mentioned above can expect harsh penalties, namely a fine of up to $5m and imprisonment for up to 20 years.

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