This one has been on my list for a while and I’m finally ready to dive in – non-fungible tokens (NFTs). In July 2017, the world of digital assets and cryptocurrency literally became an overnight business sector for corporate and securities lawyers, shifting from the pure technology sector, when the SEC issued its Section 21(a) Report on the DAO investigation finding that a cryptocurrency is, in most cases, a security HERE. The SEC’s Section 21(a) Report relied on the analysis in SEC v. W.J. Howey Co. to determine when a crypto is a security, building the guardrails to conclude that all, or almost all, cryptocurrencies at that time were/are indeed a security. For more on the Howey analysis, see HERE.
Later in June 2018, the SEC gave some relief to the crypto world by announcing that Bitcoin and Ether were likely decentralized enough as to no longer be considered a security, hedging on the conclusion as to whether they were once considered such.
Using the same analysis as a backdrop, in March 2018, the SEC issued a public statement directed specifically to online platforms for the trading of digital assets/cryptocurrencies. The statement served as a dual caution to investors and warning to platforms. In essence, if a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration (see HERE).
In April 2019, the SEC’s Division of Corporation Finance published a “Framework for Investment Contract Analysis of Digital Assets,” issued a no-action letter to Turnkey Jet, Inc. and made a statement on both. Although the guidance was appreciated, it really offered nothing new or different about the analysis, which was firmly based on SEC v. W.J. Howey Co. (the “Howey Test”) (see HERE). Other than the Section 21(a) Report and this guidance, the world of crypto regulation has been enforcement-driven.
Even accepting that a cryptocurrency is a security and trying to comply with the federal securities laws has been a difficult task. Since the issuance of cryptocurrencies, by nature and function, would involve general information and gun-jumping, a traditional IPO with S-1 would not work, not to mention the plethora of custody issues for any broker-dealer willing to act as an underwriter. See here for more information on broker-dealer custody issues related to digital assets – HERE. Traditional exempt offerings would also not work – a distribution of cryptocurrencies is never limited to accredited investors.
That leaves Regulation A; however, the process of completing the offering circular with the SEC is a large task. Blockstack was the first back in 2019 to qualify an offering circular for the issuance of a full token with properties of what could be a utility token. Others have followed and the process does seem to be gaining in popularity.
During these last few years while market participants and professionals have been navigating the securities laws related to cryptocurrencies (generally by avoiding the U.S. altogether), a whole new breed of digital assets have surfaced, including what may very well be the most powerful digital asset of them all, the non-fungible token or NFT.
NFTs use blockchain technology to establish authenticity, ownership and transferability of unique assets such as works of art, digital collectibles, music or land ownership in the metaverse. NFTs can be purchased and sold on peer-to-peer platforms using digital assets wallets. Famously, Mike Winkelmann (a.k.a., Beeple) sold an NFT digital piece of art for $69 million. The sale was the third-highest price paid for a piece of art by a living artist. It is estimated that collectors, traders, investors and speculators have spent over $40 billion dollars on NFTs to date.
The NFT market continues to explode, even though the owner of an NFT often doesn’t own the original piece of art, music, etc., only the digital marker that points to it. The idea has been touted for its potential to represent shares of a company or act as in-game currency for video games.
Unlike cryptocurrencies and ICOs, the SEC has not issued any guidance or interpretations on NFTs. Likewise, as of the date of this blog, the SEC has not initiated any NFT-related enforcement actions. It could be that an NFT, unless coupled with more, such as equity ownership, royalty or revenue rights, simply does not meet the definition of a security.
The Howey Test defines an investment contract as follows:
“… an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party….”
To further break down the analysis, Howey established a four-part test. In particular, an investment contract exists where there is:
(i) An investment of money – Although in Howey the term “money” was used, subsequent case law has expanded this concept to include any form of consideration with value.
(ii) In a common enterprise – The subsequent court cases are not consistent regarding the meaning of a “common enterprise.” The majority of federal courts define a common enterprise as involving “horizontal commonality,” which involves the pooling of money or assets from multiple investors whereby the investors share in the profits and risk in some proportion.
However, another group of federal courts define a common enterprise as involving “vertical commonality,” which focuses on the relationship of the parties. In vertical commonality, the investor’s profit or loss is subject to the efforts of the promoter putting together the deal, regardless of the existence or status of other investors. Vertical commonality can further be broken down into “broad vertical commonality” whereby the promoter’s profits are not tied to the investor’s profits, and “narrow vertical commonality” whereby the promoter only profits if the investor profits.
The bottom line is that if a commonality of enterprise is found, regardless of the form it has taken, this factor in the test will be satisfied.
(iii) With an expectation of profits – Profits can either be in the form of capital appreciation, cash return on investment or other earnings (including dividends or interest). Profits, for purposes of the Howey Test, refers particularly to a return to the investor and not necessarily the success of the enterprise as a whole. A Ponzi scheme clearly involves a security, even though the enterprise itself is designed to be a failure.
(iv) Which are derived solely from the efforts of the promoters or third parties – The efforts of the promoter(s) or third party(ies) must be undeniably significant in the success or failure of the enterprise.
Applying the Howey Test, courts have interpreted a security to include such diverse items as citrus groves, cryptocurrencies, warehouse receipts, chinchillas, minks, diamonds, bullion, pay phones, real estate and equipment, and condominium units, when they were offered or sold under circumstances involving the investment of money and expectation of a return through the efforts of others.
Directly related to digital assets, the SEC has focused on whether the purchaser has a reasonable expectation of profits (or other financial return) derived from the efforts of others. A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the assets, such as selling at a gain in the secondary market.
An NFT itself is managed by the owner and any profits derived would come from the re-sale of that unique asset and price appreciation resulting solely from external market forces impacting supply and demand, are not considered profits under the Howey test. Even if a particular NFT launch involves 5,000 variations of the same image (kitties, for example), once sold, there is no expectation of any future common efforts and ongoing relationship with the promoter. If an NFT relates to an existing asset and is marketed as a collectible with a public assurance of authenticity on the blockchain, it should not be deemed a security.
However, if NFTs are fractionalized, then a person is selling an item that they maintain management control over. In that case, the NFT starts to look a lot more like a security. Also, of course if NFTs carry rights such as equitable ownership, profit sharing, royalties, etc., they could firmly be considered a security.
Moreover, if NFTs are consistently used for deceptive practices, it becomes more and more likely that a regulator will find a way to bring them within their jurisdiction. That regulator may be the SEC, but it also could be the Commodity Futures Trading Commission (CFTC) or even the Treasury Department.
If an NFT is determined to be a security, then the platform facilitating the sale and secondary trading of the NFT would have to register with the SEC.
In addition to securities law matters, NFTs can implicate commodities laws, intellectual property laws (copyright, trademark and patent), banking laws (AML, etc.), state laws, and cybersecurity matters.