NFTs
Do Ape Securities NFTs – Or View Easier Disclosures?
NFTs (non-fungible tokens like the popular ones Bored monkey works of art) titles? The first from the Securities and Exchange Commission enforcement decision against an NFT would make you believe so. But in the analog world, digital assets like NFTs don’t fit neatly into existing boxes for what is and isn’t an SEC-regulated security.
The August enforcement action suggests when and how the SEC is likely to regulate NFTs in the future, and is likely just the opening salvo in a broader enforcement campaign against NFTs. NFT offerings that function as securities for investors will need to be registered or satisfy an exemption to avoid falling into the SEC’s crosshairs. Other regulators, such as states and foreign jurisdictions, are also process at a rapid pace with the regulation of cryptographic tokens and digital assets such as NFTs.
SEC to Impact Theory: Your NFT is a security
The SEC enforcement action (and subsequent $6.1 million settlement) against Impact Theory LLC’s NFT offering alleged that the media and entertainment company’s sale of NFTs amounted to an offering of unregistered securities. Impact Theory raised about $30 million from several hundred investors, telling them the capital raised would be put toward building its entertainment business.
Securities laws prohibit unregistered offerings of securities absent an exemption from registration – which Impact Theory has never obtained.
The majority of the Commission reached this conclusion by applying the U.S. Supreme Court ruling Howey testwhich says a bond is “an investment of money in a common enterprise with profits arising solely from the efforts of others.”
The Nine Questions of Dissent to Better Regulate NFTs
Two of the five SEC commissioners disagreed of the landmark Impact Theory ruling, concluding that the company’s promotional statements did not meet the level that required regulation by the SEC. They presented nine thought-provoking questions to their fellow commissioners, the discussion of which they believe could help the SEC better regulate amorphous NFTs.
The questions urge the Commission to be more proactive in setting barriers to the sale of NFTs, rather than continuing to rely on a case by caseregulation-by-enforcement approach, which makes it challenging for lawyers advising NFT clients on how to avoid legal problems.
Question 1, about how to categorize NFTs, provides a strong clue about the possible regulation of NFTs by the SEC.
How will the SEC categorize NFTs?
It is particularly difficult to define what NFTs are, and properly categorizing instruments is essential for fair and effective regulation. A useful way to think about them and appreciate their versatility is that NFTs are digital certificates of authenticity that represent ownership of an underlying asset. They create a unique identifier on an open blockchain that enables NFTs to maintain significant value. Otherwise, something that is digital could be endlessly reproduced exactly like the original, making the value of the original extremely limited. NFTs solve this problem for digital artists and other creators by verifying authenticity and thus creating scarcity (and, their creators hope, adding perceived value).
NFTs are unique and come in a variety of forms. NFTs are not limited to the ownership of digital art. They can be physical objects, including sports collectibles or one music album. They can also be non-artistic, such as Walmart NFT development for managing your supply chain. The possible uses of NFTs are many and wide-ranging, but at its core, an NFT protects ownership of a unique creation. The value of an NFT depends on its scarcity and popularity.
The critical securities regulatory issue in evaluating an investment instrument is not what it is called or how it is packaged. What matters is your function. Is money solicited from investors for a common venture with the expectation of profits through the efforts of others? Or, to be more concrete: is an investor buying a work of digital art or is he investing primarily in a business?
The investor’s expectation of what they will receive in exchange for their money can be decisive. That’s why a stock certificate proving ownership at the Green Bay Packers football team is not a security (it functions as a novelty or collectible; an investor has no expectation of profit), and an investment in an orange grove can be a security rather than just a real estate investment (howey case facts). This is also why Goals abandoned stablecoin Diem (originally Libra) was carefully structured not raising capital to build the currency infrastructure (Howey’s “common enterprise”) and why the SEC gives fully realized results (“sufficiently decentralized”) cryptocurrencies Bitcoin and Ether a free pass.
Based on the Impact Theory ruling, one would predict that the SEC will be very likely to continue to review statements made to investors to motivate them to invest and about how that investment money was used by a company that is being investigated. How a company creating NFTs for an offering handles these two factors will likely determine whether the SEC views your NFT as a security.
This is confirmed by the agency’s second NFT application town against Stoner Cats 2 LLC in September. The Commission – again in a 3-2 split decision – focused on investor expectations and how investment money was used. The investors had reason to believe they would profit from their investment and knew their money would go toward producing an animated web series called “Stoner Cats.”
The show was not complete when investors were solicited and NFTs were sold. The program needed capital from these NFT investments to fund the project until completion. When these two factors (profit expectation and funds used as business capital) are found in combination, this Commission will likely always find that the NFT in question is an unregistered security.
The SEC wants to regulate NFTs
Most Commissioners want NFT regulation to be recognized as falling within the purview of the SEC, and will likely fight to apply the current securities regime to NFTs when issuers offer NFTs to raise money to build businesses and when promoters make promises of that investors will profit.
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