Non-Fungible Tokens (NFTs) have been around since 2014, but their entry into the public spotlight has been marked by several high-profile sales in recent years. Christie’s history-making auction of Beeple’s “Everydays—The First 5,000 Days,” a digital work of art that sold for $69.3 million earlier this year, is an example. NFT interest also experienced a resurgence this year due to the meteoric rise in popularity of NFT projects like CryptoPunks, CryptoKitties, and Bored Ape Yacht Club. Today, the average sale price of a CryptoPunk on OpenSea is 228 ETH (Ethereum), or approximately $1 million USD. These sales have made the prospect of getting rich from NFTs a hot topic among creators and investors. New NFT projects are appearing every day and questions are swirling about whether the Securities and Exchange Commission (SEC) will deem NFTs to be securities, subjecting them to state and federal securities regulations.
NFTs are digital entries, recorded on a blockchain, that represent objects such as videos, music, or works of art. They differ from other blockchain-based assets such as Bitcoin, Ethereum and other cryptocurrencies because NFTs are not interchangeable – no two tokens are identical (i.e., non-fungible). Most NFTs are currently minted on the Ethereum blockchain, but other platforms, like Solana, are increasingly competing for market share in the space. NFTs can be bought and sold peer-to-peer or on dedicated marketplaces. Technological developments in the blockchain space have led to NFTs with unique features, including royalty mechanisms and the fractionalization of NFTs.
The SEC evaluates digital assets the same way as traditional assets to determine whether they are securities. Unlike initial coin offerings (ICOs), which are a type of digital asset that has drawn significant scrutiny from regulators, NFTs have not been the subject of interpretive guidance by the SEC. To date, the SEC has not initiated an enforcement action against the creator of an NFT or the operator of a platform that facilitates the offer and sale of NFTs. The question of when an NFT is a security is unclear.
The definition of “security” under the Securities Act of 1933 and Securities Exchange Act of 1934 are similar and broad enough to likely cover some NFTs. Section 2(a)(1) of the Securities Act defines security as:
While the definition of security is broad, it does not explicitly include digital assets or NFTs. In prior enforcement actions, the SEC has argued offerings of digital assets qualify as securities because they are investment contracts.
The test to determine what constitutes an investment contract was articulated by the U.S. Supreme Court in SEC v. W. J. Howey Co. Under the Howey test, an investment contract is a contract, transaction or scheme involving (i) an investment of money, (ii) in a common enterprise, (iii) with the expectation that profits will be derived from the efforts of the promoter or a third party. The Howey test arguably brings many non-traditional offerings within the definition of the term security.
Although the SEC has not yet provided guidance on when an NFT is a security, the SEC has noted:
Thus, the determination of whether an NFT is a security is fact-specific, requiring an analysis of its individual characteristics and features. For NFTs that simply constitute art or collectibles, they are unlikely to be deemed securities. These NFTs are basically stand-alone products whose value is determined at a sale that is made directly to a buyer. For such NFTs to appreciate in value, there is generally no expectation or requirement that profits will be derived from the efforts of promoters or third parties. As noted by the SEC, “[p]rice appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered ‘profit’ under the Howey test.” That is, an NFT should not be deemed a security simply because it can increase in value.
As NFTs continue to proliferate, however, the analysis is not so straightforward and new regulatory questions will arise. Recent NFT projects are beginning to introduce complex features involving a broad variety of digital property rights. One example is the introduction of fractional NFTs (F-NFTs).
Simply put, an F-NFT is portion of an NFT. The concept of F-NFTs came into existence to allow NFT owners to mint tokenized fractional NFTs and share the ownership of the asset with others. The interest in fractionalization is not surprising given the high sale price of some NFTs and the popularity of crowdfunding. Consider the example of the iconic Doge meme NFT that sold for $4 million in June of this year and is now speculated to be worth $220 million after being fractionalized into 17 billion F-NFTs. Notably, these F-NFTs are fungible because they can be exchanged for one another as they are all part of the same NFT.
F-NFTs that allow numerous buyers to acquire partial ownership in the NFT arguably increases the likelihood the NFT could be considered a security. Efforts to create fractional interests and related promotional arrangements will likely raise questions about whether such actions begin to resemble investment products classified as a security under the Howey test. A primary concern would be how the F-NFTs are issued and subsequently traded.
While it is not currently against the law for someone to buy, resell and promote the value of digital assets, SEC Commissioner Hester Peirce warned that issuing F-NFTs could be considered investment contracts under securities laws. At the recent Security Token Summit 2021, Peirce said, “you have to be very careful if you decide to take a bunch of NFTs, put them in a basket, break them up and then sell fractional interests or you decide to take one NFT and sell it in parts.” Peirce emphasized that the “definition of security can be pretty broad” and that certain fundraising efforts related to NFTs may raise the same kinds of questions that ICOs have raised.”
Another feature of certain NFTs that can potentially deem them securities is a royalty feature. This feature is built into the relevant smart contract and automatically transfers to the original NFT issuer a portion of the sale price each time the NFT is sold, even long after the initial mint of the NFT. The original NFT issuer could potentially choose to sell such rights to future royalties on a secondary market, perhaps even combining them with rights to proceeds from other NFTs they created. Some commentators have suggested that, depending on how the royalty is structured, an NFT that guarantees a percentage income stream from sales of a pool of assets could be considered a fixed-income security.
Ultimately, the determination of whether an NFT is a security depends on the economic reality of the transaction and the manner in which the digital asset is offered and sold, including promotional and marketing efforts. If a particular NFT is deemed to be a security, every sale would need to be registered or exempt from registration under U.S. securities laws. Platforms facilitating the sale and secondary trading of the NFT may have to register with the SEC as an exchange or alternative trading system and broker-dealer.
To minimize the potential for regulatory liability, NFT issuers should avoid marketing NFTs as an investment that can reward buyers with appreciation, profit or dividends. The concern here is that such marketing could render an NFT a security due to the inherent promotion of a secondary market for the NFTs. Issuers should also avoid marketing NFT sales as a fundraising effort to build a platform for future sales, employing promoters or third parties whose marketing efforts are intended to drive the NFTs’ appreciation and giving NFT buyers the impression that they can expect capital appreciation or profits from the digital asset.
The question of whether an NFT is a security is highly fact specific. It may take some time, but regulators will undoubtedly turn their attention to NFTs in the future, especially as NFT products become more complex and cases of fraud continue to occur. NFT creators should consult with experienced legal counsel to understand the risks and potential regulatory liability associated with their NFT project.