NFTs and Securities Law: What You Need to Know — An Overview of US Securities Laws for NFT Creators
Dec 26, 2022
For artists and creators benefitting from the new opportunities afforded by minting studios such as Manifold, the US securities laws are probably the farthest thing from their minds. Yet, although the application of securities laws to NFTs is far from clear, the regulatory environment for creators is increasingly unsafe. The SEC’s pattern of regulation by enforcement in the crypto space seems to have arrived to NFTs, with Yuga Labs being the subject of an investigation into its alleged unregistered securities offerings. Crypto-sympathetic SEC Commissioner Hester Pierce has also weighed in, stating that “the SEC has provided very little clarity [on NFTs]” and that, “There's a lot of ambiguity. And in situations where there is this much ambiguity, I think people really need to be very careful.” So how can one be careful?
Any honest answer must include the caveat that, unless the SEC abandons its misguided policy of regulation by enforcement and instead articulates clear guidelines that creators in the crypto space can work with, there are no guarantees as to what exactly constitutes a “security” in the eyes of the SEC. However, some familiarization with the body of law that is used to determine what is a security, and examination of how the dominant use cases fit within that framework can be invaluable for creators to bear in mind.
The first step in determining whether or not the sale of an NFT is a security offering is an examination of the two primary legal tests for securities. Under the Securities Act of 1933, the definition of a security includes stocks, notes, bonds, treasury stock, futures, security-based swaps and a host of other types of financial instruments as well as so-called investment contracts. What defines an investment contract was answered in a line of cases beginning with the Supreme Court’s 1946 decision in SEC v. W.J. Howey Co. This case and its progeny have articulated a four-factor test to determine whether a contract or scheme meets the definition of an “investment contract.” These four factors are: (1) the investment of money, meaning that the investor has given some definable consideration; (2) in a common enterprise, which means the investor’s fortunes must be intertwined with those of other investors (“horizontal commonality”) and/or the efforts of the promoter of the investment (“vertical commonality”); (3) with the expectation of profits, meaning that the investment must be purchased with the reasonable expectation that its value will appreciate or that the investor will receive earnings on the investment; and (4) with such profits to be generated primarily from the efforts of the promoter or some definable third party. This test and its accompanying body of case law are the relevant starting point for a security law analysis of the vast majority of crypto and NFT use cases, and will be the focus of this article.
However, before embarking on a Howey analysis of the predominant NFT use cases, it is important to remember that the Howey test is not the only legal test for securities. As articulated above, the definition of a security under the Securities Act includes a “note.” In Reves v. Ernst & Young, the Supreme Court stated that a legal document evidencing a promise to pay a debt is presumptively a security unless it bears a “resemblance” to: (1) a note delivered in consumer financing; (2) a note secured by a mortgage on a home; (3) a short-term note secured by a lien on a small business or some of its assets; (4) a note evidencing a character loan to a bank customer; (5) a short-term note secured by an assignment of accounts receivable; or (6) a note that formalizes an open-account debt incurred in the ordinary course of business. The Reves test is often overlooked in the discussion of the applicability of the securities laws to crypto, but it is particularly relevant to a discussion of NFTs. This is because NFTs can evidence ownership of just about any off-chain asset or right, and when such an off-chain asset or right is a promise to pay debt, that is a security. Thus, an NFT evidencing a loan arrangement wherein the holder of the NFT is entitled to be repaid (with or without interest) the value of the assets used to purchase the NFT is a security irrespective of any Howey test analysis of such an NFT. Similarly, a tokenized version of an off-chain asset that is itself a security such as a stock or a bond in the form of an NFT would render that NFT a security itself.
The most commonly known use case of NFTs is the creation and sale of digital art. In most of these cases, the sale of such NFT is probably not a security. To understand why, it is helpful to revisit the Howey test.
The first prong of the test requires the investment of money. This prong is almost always satisfied because the exchange of fiat or digital assets for the NFT is valuable consideration, and interestingly, at least in the case of fungible tokens, the SEC seems to hold that the first prong is satisfied even in an airdrop, where digital assets are directly distributed to the wallets of recipients if such airdrop is made with the intent of widely disseminating and promoting the token so as to create a broad secondary market into which the promoters can later sell their tokens. Although this reasoning seems less applicable in the case of NFTs, it might be relevant for fractionalized NFTs or other NFTs that form a set wherein the value of any individual NFT is correlated with the value of the other NFTs forming the set.
The second prong of the Howey test is the “common enterprise” requirement. In contrast to the case of fungible tokens, where the second prong is almost universally met, in the case of NFTs, it can be highly dependent on the business model of the creator. Some cases are clear. For example, in the case of fractionalized NFTs, much like any fungible token, there is horizontal commonality because when the value of the underlying NFT increases, the value of every percentage ownership of that NFT will increase such that each holder of the F-NFT accrues the benefits pro rata. There is also vertical commonality to the extent that the creator of the NFT has retained any F-NFTs for him or herself or plans to sell additional F-NFTs. The common enterprise requirement is also met in the case of multi-edition NFTs of the same artwork, or artwork that is part of a collection of images where the value of each individual NFT within the collection is heavily correlated with the value of other NFTs within the collection. Where the collection as a whole succeeds, it benefits each individual holder, as well as the promoter of the collection who can sell additional NFTs at a higher price. However, the second prong might not apply to an artist minting 1/1 NFTs of distinct works of digital art that do not form a cohesive collection, such that the correlation between the value of any two such NFTs might be exceedingly small or non-existent.
The third prong of the Howey test requiring a reasonable expectation of profits is the one which probably renders the majority art NFTs non-securities. According to the Supreme Court in United Housing Foundation, Inc. v. Forman, “when a purchaser is motivated by a desire to use or consume the item purchased . . . the securities laws do not apply.” Thus, broadly speaking, items purchased for their aesthetic value or as collectibles are not securities in the same way that non-digital artwork is not a security. However, the much-maligned recent decision SEC v. LBRY, Inc. to some degree circumscribes that argument, with the decision noting that “[n]othing in the case law suggests that a token with both consumptive and speculative uses cannot be sold as an investment contract” and that evidence that “purchases were made with consumptive intent” does not negate a finding that the token was sold as an investment contract. The court, in finding the LBRY tokens to be securities, pointed to the statements of the management indicating that buying the said tokens was a good financial investment, although the decision also suggested that the LBRY business model, wherein the tokens would appreciate as the enterprise as a whole grew, might have been sufficient even without such statements to render the token a security. Again, the decision referred to fungible, rather than non-fungible tokens and it is difficult to know with any degree of certainty how applicable it is to non-fungible tokens. However, some generalizations can be extracted about the type of NFT which is more or less likely to be viewed as a security by the SEC.
On one end of the spectrum is a 1/1 fine art NFT, the sale of which grants some rights in the artwork and the creator makes no mention of the appreciation potential of such NFT—this is almost certainly not a security. More likely to be viewed as a security is a fractionalized NFT with a mechanism to appreciate the value of the F-NFTs, for example by buying and burning them, or where the NFT directly promises earnings linked to the underlying artwork, such as royalty rights.
The applicability of the fourth prong of the Howey test, requiring the essential managerial efforts of the promoter or some definable third party, to an NFT sale is also very fact specific. Generally, if all that is sold are rights in an already finished artwork, this prong is unlikely to be met. However, if that artwork is a part of a collection such that the value of each individual NFT within the collection appreciates by the promotion and/or completion of the collection, then the fourth Howey prong is likely met. The same is true of an NFT that is part of a larger scheme, such as an in-game or in-app NFT that has value to the extent that the game or app has value and in turn, relies on the managerial efforts of the designers of the game or app.
Returning to the question of how an NFT creator can be “careful” in an era of regulation by enforcement; although the law on this question is quite murky and unclear, when navigating the new various use cases for NFTs and mechanisms to effectuate an NFT sale, it is important to speak to counsel and be empowered with an understanding of the securities law questions that could be involved.