Unraveling the Rug: The Dark Side of Crypto

Fortune.com

What is a crypto rug pull?

Lately, many high-profile public figures have been involved in crypto scandals. Hailey Welch, also known as the “Hawk Tuah Girl”, launched the much-anticipated $HAWK meme coin on the Solana blockchain platform on December 4th, but within minutes of its debut, its value collapsed by over 93%. Two weeks later, Chinese online dissident “Teacher Li” launched $Li, but its value dropped by 80% within the same day. The trend spread from online personalities to the political arena. Argentine President Javier Milei is embroiled in a corruption scandal for his promotion of meme coin $LIBRA, whose price similarly collapsed hours after its launch. However, none is more brazen than President Donald Trump’s $TRUMP and First Lady Melania Trump’s $MELANIA, both of which were launched before the inauguration in January. $TRUMP is down by 83% since its launch and $MELANIA has dropped 96% of its value from its all-time high. 

The series of crypto scandals has brought “rug pull” into people’s common parlance, but what exactly is a crypto rug pull? Datavisor defines a rug pull as a “cryptocurrency investment scam where the creators or developers of a cryptocurrency project suddenly abandon the project or exit scam, taking all the funds invested by users with them.” There are several types of rug-pull scams. 

Fake coin launches often use celebrities as the face of a new cryptocurrency or token, which they promote via social media. The celebrity is known as a KOL (Key Opinion Leader). Once the project team raises funds from investors eager to participate in the new project, the promoters disappear with the funds and leave investors holding the bag. In a fake coin launch, the scam is so pure that there is never a functioning cryptocurrency. Exit scams operate similarly but are slightly more sophisticated. Exit scammers will develop a working cryptocurrency or token for a period of time before manipulating the value of the coin (including suddenly taking the coin offline) and disappearing with investor funds. There are also two variants of exit scams, hard rug pulls and soft rug pulls. In a hard rug pull, the project team suddenly and completely disappears, taking all the raised funds with them and cutting off all possible channels of communication. In a soft rug pull, the project team slowly disengages from the project, reducing their effort and involvement in maintaining the cryptocurrency. While a soft rug pull may give investors some warning signs, the gradual pace may also disarm investors’ alertness. 

Another classic type of rug-pull scam is pump-and-dump. In a pump-and-dump scam, the project team artificially inflates the price of a token either through coordinated buying or using celebrity promotion to create a frenzy in the market while holding a large amount of the cryptocurrency. Once the price of the cryptocurrency reaches a high, the project team sells its holdings and cashes out at a high price while flooding the market with more supply and thus crashing the price. The universe of crypto scams is endless. The project team can also conduct a liquidity pull by creating a pool of cryptocurrency, including both the new cryptocurrency and a more widely traded, relatively more reputable crypto, such as Bitcoin. The inclusion of a more reputable coin boosts investor confidence, and once enough investors’ cash is raised in the pool, the project team takes out the anchor crypto and crashes the price of the pool. Crypto scammers can employ a variety of techniques at different stages of launching a cryptocurrency to complete their scams. 

Victims’ legal recourse 

Rug-pulling scams can cause tremendous financial harm to investors, so it's important to understand what recourse is available. 

Securities fraud (Rule 10b-5)

Victim-plaintiff’s first potential cause of action might be securities fraud. However, to hold scammers liable under securities law, plaintiffs must first cross a threshold issue of establishing that the transaction qualifies as a security. Using the Howey test, a court will consider the transaction as a security if the plaintiff can demonstrate that the transaction involved investing money in a common enterprise with an expectation of profits. If the court finds that the cryptocurrency meets this standard, several civil remedies are available to plaintiffs if they can prove that the issuer engaged in fraud. Once a plaintiff establishes that the cryptocurrency or token is a security, plaintiffs may sue under Rule 10-b of the Securities Exchange Act to recover their lost investment and damages. In rare cases, the government may intervene through a direct civil action brought by the SEC or through criminal prosecution by the Department of Justice or a state Attorney General.

However, satisfying the Howey test is not a foregone conclusion, especially for decentralized blockchain currencies. Digital “assets” can have varying and often convoluted technical structures, making it difficult for courts to determine whether a given coin is a security. Highlighting this confusion is the fact that even Bitcoin is not considered a security. Courts can look to whether the cryptocurrency sought any investment before its launch. If it did, then the coin is more likely to pass the Howey test because it requires investment on behalf of the fundraisers. 

This can lead to confusing outcomes. For example, the SEC does not consider Bitcoin to be a security despite its high USD value. On the other hand, plaintiffs in the Hawk Tuah Case have made progress arguing that $HAWK is, in fact, a security because Welch and the developers of $HAWK publicly promoted the meme coin before its release on crypto exchanges. Adding to the confusion is the fact that cryptocurrencies are not subject to the traditional SEC rule requiring registration of any publicly traded security, so long as the investors and developers complete a Simple Agreement for Future Tokens. SAFTs are contracts between the promoter and buyer of a coin that are commonly used in fake coin launches. Fortunately for investors, though, SAFTs are considered securities and therefore are subject to Rule 10b-5. 

Commodity Fraud

In the famous debate on whether crypto is a security or commodity, if victims cannot rely on civil actions based on securities fraud, they can proceed under commodity fraud according to the anti-fraud provision in Section 6(c)(1) of the Commodities Exchange Act.  

Wire Fraud & Common Law Fraud 

Departing from laws regulating the financial market, crypto rug-pull scam victims can rely on either wire fraud or common law fraud. The jurisdictional requirement for wire fraud is fairly easy to establish, so the analysis will focus more on the elements of common law fraud. 

In a common law fraud cause of action, a plaintiff has to show that a false representation is made about the project, with the project team having the requisite knowledge of the falsity of the statement and the intention to induce reliance. Then, investors justifiably rely on such representation and sustain actual damages. 

The unique nature of rug-pulls may give rise to some surprising obstacles to an otherwise slam-dunk case of fraud. When a scam becomes blatantly obvious, victims would have a hard time showing false representation when the project team essentially doesn’t promise anything and only relies on the popularity of the public figures who promote the coin. When such scams become so prevalent, plaintiffs would also have a hard time showing justifiable reliance. In an ironic twist of fate, the more prevalent a type of scam is, the more challenging it is for plaintiffs to prove their cases. 

Market self-regulation?

The four crypto scandals cited in the introduction were all launched on the Solano network, which naturally brings the public’s attention to Solano. Solano is a crypto ecosystem built for speedy and low-cost transactions. Because of its low barrier to entry, it attracts many would-be scammers. It is further alleged that the platform is either directly involved with many of the scams or at least complicit in promoting the scams, such as charging a fee for “degen” traders to get in the game with the insiders before the general public.  

In the universe of crypto scams, ecosystems and platforms play a major role in vetting the credibility and integrity of cryptocurrency project teams. The question remains whether market intermediaries and crypto exchanges themselves would have the incentive to regulate the market. That depends on the incentive structure of a crypto exchange. If a crypto exchange derives its revenue from the number of transactions on the platform, it would have the incentive to build a positive reputation to attract more investors. However, if an exchange is in cahoots with rug-pulling scammers, it has no incentive to provide trust in the market. 

More established and reputable crypto exchanges, however, have implemented measures to mitigate rug pulling. For instance, Coinbase uses a detection software that has identified and blocked over 700 tokens posing critical risks to users. Before launching new tokens, Coinbase also uses objective criteria to screen and filter out applications submitted to the Coinbase Asset Hub for legitimacy, legality, safety, integrity, and reputability. As a result, only a selective 10 percent of applications are identified as potential candidates for listing on Coinbase Exchange. Similarly, Robinhood has implemented a graph intelligence system, which allows it to identify fraud by visualizing connections between accounts and identifying coordinated efforts. Robinhood achieves this by using data modeling to connect accounts, vertex-centric intelligence to identify first attackers and similar bad actors, graph-centric intelligence to find groups who exhibit risky behavior, and data processing and serving to process users’ workload. While a 2024 report by Robinhood itself claims that these new measures have been successful in mitigating fraud on its platform, the company has a history of challenges in its anti-money laundering and cybersecurity compliance programs, as seen with the New York State Department of Financial Services’ fining of Robinhood in 2022 for its cybersecurity failures. 

The alleged coordination between a platform and “degen” traders also brings up an interesting dynamic in the market. “Degen” trading, short for degenerative trading, essentially means those investors who engage in high-risk, high-reward trading in the crypto market and essentially treat cryptocurrency as pure gambling. Their cynicism might reflect the reality of the market, but also actively contributes to continuous volatility and perpetuates the occurrences of rug-pull scams, which not only leave the targeted assets vulnerable but also influence the broader crypto market despite crypto platforms’ continued efforts to enhance their security measures. When the market is rampant with speculation, no law can rescue extreme risk-taking and sometimes pure stupidity. Maybe the world of cryptocurrency is returning to a tradition of caveat emptor?

Conclusion

While crypto exchanges are incentivized to foil rug-pulling schemes ex-ante, doing so is often impossible because promoters are presumed to act in good faith. Moreover, “degen” traders may purposefully invest in projects that they know have a high likelihood of failure, by rugpulling or otherwise. As a result, courts have the difficult task of determining the validity of an investment under the Act and whether plaintiffs are worthy of recovery. Mixing proof of intent with the complex nature of crypto transactions creates an unenviable position for courts that are probably hoping for clearer Congressional guidance in the near future. In any event, investors should be wary of crypto endorsed by their favorite celebrity or influencer.

*The views expressed in this article do not represent the views of Santa Clara University.