Rug Pulls and Their ICO Predecessors
In the NFT world, a rug pull is when a founding team pulls the rug out from under the NFT holders, leaving them with a worthless asset. Here's how this happens.
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An exciting new NFT project spins up with cool artwork and a lot of hype. They launch a website and talk about the amazing roadmap of future development for the project. Maybe they plan to build a video game for their NFTs. Or maybe they plan a fully immersive Metaverse for them. There are big plans for how the founding team is going to use the proceeds of the NFT sale to build a community that everyone will want to join in the future. They often get big social media influencers as paid promoters to tout the project on Twitter and Instagram. You might see your favorite athlete or musician on their website as a contributor. There is a thriving Discord community with 50K+ members.
The mint day comes, and the project sells out 10,000 NFTs at ETH 0.1 ($300) in 10 minutes and brings in $2-3MM in cash. You are pumped that you were able to secure 5 of these “hot” NFTs at the mint price. You see some secondary trades on OpenSea, and the price is moving up as more people jump onboard. You have dreams of owning the next Bored Ape or CryptoPunk. You start spending your million dollar profit you are sure to make.
That is when the trouble starts. The loudest voices on Discord stop posting about the project. The official Twitter account goes quiet. Maybe the website is no longer active. The price on OpenSea plunges to zero. You got “rug pulled”! In the NFT world, a rug pull is when a founding team pulls the rug out from under the NFT holders. Likely, there never was a plan for that video game or other community activities. It was at best a cash grab and at worst a scam from the start.
I’ll start with my own dumb mistake. I bought three Vault of Gems NFTs at the mint for ETH 0.08 each ($330 at the time) back in September. The project seemed legit. The founders had big social media accounts. The Discord had 20K people in it. It was getting pinged with Discord DMs about the mint. NFL star Antonio Brown and rapper Trippie Redd were posting on their socials about the project. The biggest red flag, which I ignored, was that the founders of the project were all pseudonymous. But hey, that happens on lots of NFT projects.
The problems started on the mint date. Their plan was to sell 12,345 NFTs. I was pumped to get in and mint my three NFTs right when it launched. I watched the mint count, and it wasn’t going up fast enough. After an hour, it was clear it was not going to sellout, a big red flag in NFT sales. By the end of the day, they had only sold 4K+. The Discord was going crazy. People who had minted were screaming at the founders to do something, anything. They tried a few things to spur sales, but nothing moved the needle. In the end they sold 4,803 for proceeds of about $1.4MM. And then, everything went quiet. No activity in the Discord from the founders, no posts on Twitter. Eventually the website was shutdown. All those fancy plans in the roadmap, forget about it.
I got rug pulled out of about $1,000. For me, I chock it up to a learning experience with some short-term pain. The biggest lesson was about really understanding who the founders are and what their reputations and capabilities are. I’m not buying another NFT project unless I believe in the founders the same way I would when making a VC investment in a startup.
If you’re looking for historical precedence for NFT rug pulls, you only need to go back to the Initial Coin Offerings (“ICO”) from 2017. After the first big runup in the price of Bitcoin, new coins started popping up. Coins like Mastercoin and Ethereum did well, and fraudsters took notice. In 2017, hundreds of new coins were minted and sold to buyers with names like Sirin Labs, Tezos, Filecoin, Dragon, and more. Some of these coins sold out their initial allocation in a matter of minutes with proceeds of over $100MM each. Celebrities like Paris Hilton, Floyd Mayweather, and tons more got in on the game. They promoted the ICO sales in exchange for a fee, usually paid in tokens. The social networks played along too. They allowed ICO teams to do paid advertising to target buyers. Most of these coins failed, with prices plummeting to zero. A bunch of the ICO teams were prosecuted in the U.S. and abroad for securities fraud, and several went to jail or paid large fines.
How are regulators addressing NFT rug pulls? Last month the U.S. Department of Justice brought the first case against NFT fraudsters. They accused two individuals of selling $1.5MM worth of Frosties NFTs with no intention to do anything except run off with the cash, which is what they did. They pair face serious jail time and a large fine if convicted. It will take time for this to play out, if the individuals chose to fight the charges and don’t plead guilty. We’ll keep an eye on this, and you can certainly expect to see more cases brought for rug pulls.
Interestingly, while the ICO cases were brought as securities fraud, this NFT case is under the more general wire fraud and money laundering statutes. As I’ve written about before, there is ambiguity on whether NFTs are “securities” under U.S. law. I think it is telling that the DoJ did not choose to prosecute this case as securities fraud. It took the defense option away to claim no laws were broken since the NFTs are not securities. It also meant that the court will not get a chance to rule on this important issue now. I’m no lawyer, but I wonder if a future defendant will be able to point to this decision by the DoJ and say “they didn’t use securities law in that case, so NFTs aren’t securities”. If you’re a lawyer reading this, I’d love to hear your thoughts on the subject.
I’m going to wrap it up here on this topic. I hope this helps you stay away from rug pulls in your NFT shopping.