Not Fun Times for Non-Fungible Tokens (NFTs): The SEC Vows to Take a Harder Stance on NFTs
It is no secret the Securities and Exchange Commission (“SEC”) has been ramping up its regulation of cryptocurrencies in the past several years. (Packin, Forbes). However, in the absence of well-fitting regulations, the crypto community has been struggling to understand how securities laws may or may not apply to specific digital assets. Id. According to recent reports, the SEC is looking to expand its regulation even further by targeting certain non-fungible tokens (“NFTs”). (Robinson, Bloomberg).
NFTs are digital assets that denote ownership of unique real-world or virtual objects, such as art, music, sports memorabilia, in-game items, real estate, and videos. (Conti and Schmidt, Forbes). Though they have been around since 2014, in recent years, NFTs have been gaining immense popularity. Id. In 2021, approximately $44 billion worth of cryptocurrency sent from smart contracts on the Ethereum blockchain was tied to NFTs. (Robinson, Bloomberg). Because NFTs represent ownership of objects, many are wondering how, why, and more importantly, when U.S. securities laws apply. Id. To answer these questions, one must first understand how the SEC analyzes securities. Id.
In determining whether an investment contract is a security, the SEC applies the Howey test, which comes from the 1946 U.S. Supreme Court decision in SEC v. W.J. Howey Co. Id. Under the Howey framework, an investment contract generally falls under the SEC’s jurisdiction when it involves an investment of money in a common enterprise with an expectation of profits to be predominantly derived from the entrepreneurial or managerial efforts of others. Id.
One must apply the Howey test on an individual basis to determine whether an NFT might be an investment contract, or a security. Id. To do so, it is easiest to divide the Howey test into a three-parts:
1. Investment of Money. All investment contracts for securities require an investment of money. (U.S. Securities and Exchange Commission). It does not matter whether the investment of money is in the form of fiat currency, another digital asset, or some other form of consideration. Id. NFTs typically require an investment of money, so the first prong of the Howey test is usually met. (Conti and Schmidt, Forbes).
2. Common Enterprise. Common enterprises can take the form of horizontal commonality or vertical commonality. Revak v. SEC Realty Corp., 18 F.3d 81, 87-88 (2d Cir. 1994). Finding either form of commonality meets the common enterprise requirement of the Howey test. Id. The SEC has taken a flexible approach to finding common enterprise in digital assets by saying that it “typically exists.” (U.S. Securities and Exchange Commission).
Horizontal Commonality. At a basic level, horizontal commonality is when investors pool funds together and their returns fluctuate collectively. Revak v. SEC Realty Corp., 18 F.3d 81, 87-88 (2d Cir. 1994). Sometimes NFT ownership of an object is fractioned so that multiple individuals own a percentage of a share in a specific object. (Gatto, JDSupra). The fractionalization creates digital scarcity by limiting the amount NFTs available. (Conti and Schmidt, Forbes). As a function of economics, the object’s value will likely increase because of fractionalization. Id. If multiple individuals invest in NFTs, and as a result, the object the NFTs are backing increases in value, it seems reasonably likely this could be considered horizontal commonality. (Hanson, King & Spalding).
Vertical Commonality. Vertical commonality requires a showing that the investors are dependent upon the expertise or efforts of the investment promoter for their returns. Revak v. SEC Realty Corp., 18 F.3d. 81, 87-88 (2d Cir. 1994). Because vertical commonality focuses "on the relationship between the promoter and the body of investors," if an NFT’s value is dependent on the success of a promoter, vertical commonality may be found. Revak v. SEC Realty Corp., 18 F.3d. 81, 87-88 (2d Cir. 1994). For example, in promoting the sale of an NFT, if a company holds out its creators or agents as being able to possibly increase profits of investors, this may be considered vertical commonality. Munchee Inc., Securities Act of 1933 Release No. 10445 (“Munchee Order”) (December 11, 2017).
3. Expectation of Profits to Be Derived Predominantly from the Entrepreneurial or Managerial Efforts of Others. An expectation of profits is an expectation of increased value in an investment, as well as an expectation that an investment’s appreciation may result in profits through sale on a secondary market. (U.S. Securities and Exchange Commission). That expectation of profits is derived from the entrepreneurial or managerial efforts of others when there is an expectation that someone’s expertise, skills, or actions are likely to increase profits of investors. Id. If someone holds themselves out as being able to raise profits, it is likely this requirement has been met. Id. For example, there may an expectation of profits derived from the efforts of others when there is a central authority selling NFTs in a presale context, when investors are receiving a right to a revenue stream, or when someone is promoting increased profits through their expertise. (Gatto, JDSupra). Price appreciation of an object solely through outside market forces, without further entrepreneurial or managerial efforts does not usually meet this prong of the HoweyTest. (Levin, Global Legal Insights).
Not all NFTs meet the Howey framework, but the SEC is beginning to find that certain NFTs are being used to raise money in a manner similar to securities. (Gatto, JDSupra). Whether or not an NFT meets the Howey test should be determined on a case-by-case basis. (Levin, Global Legal Insights).
With the SEC beginning to take a harder look at NFT marketplaces for regulatory violations, NFT creators participating in functions that closely resemble traditional security offerings may want to consult legal counsel to determine their level of risk. (Benson, Decrypt). There are a few “red flags” that signal the SEC might consider an NFT a security. (Gatto, JDSupra). First, the SEC has specifically stated that it is looking into fractional NFTs. (Robinson, Bloomberg). Second, the SEC has historically been stringent about initial coin offerings, so anyone operating a pre-sale of NFTs to raise capital should be wary. (Benson, Decrypt). Lastly, any NFTs that represent a right to a revenue stream are towing a close line to resembling a security, because they essentially meet every requirement of the Howey test. (Gatto, JDSupra).
Between the fast-paced and ever-changing nature of the crypto industry and the absence of well-fitting regulations, it is crucial to perform a thorough legal analysis before launching an NFT. It is the safest and likely the only route to avoiding an enforcement action and potential sanctions.