Is your NFT a security? What does that even mean and why should you care?
Perhaps the most significant exposure any NFT project faces is the potential of being classified by the United States Securities and Exchange Commission (SEC), as a ‘security’. Such a classification would require the NFT creators to be subject to a long list of laws and procedures that govern securities offerings.
Last May, a class action was filed in the U.S. against Dapper Labs, the creator of CryptoKitties and NBA Top Shot. The complaint alleges that NBA Top Shot’s Moments NFT series are securities and that their promotion, offering, and sale by Dapper is in violation of U.S securities laws.
While this may end up being the first U.S. case regarding NFTs and securities laws to be heard in court, it will certainly not be the last. To those familiar with the class action wave that followed the big ICO craze of 2017, it was only a matter of time until such lawsuits reached the NFT community.
The NFT craze has already gotten the SEC’s attention, with SEC Commissioner Hester Peirce, warning that “since the SEC’s “definition of security is quite broad…people need to be thinking about potential places where NFTs might run into a securities regulatory regime”.
Let’s break this down so it’s easier to comprehend from a creator’s or an investor’s perspective.
While the first NFT collections offered a mere jpg image presented as a digital collectible, recent NFT projects offer many advanced features such as exclusive membership perks, in-game features which can be used in collaboration with third-party gaming platforms, or rights to receive a certain portion of the revenues generated from different resources which are tied to the collection, such as monetization of certain IP and other digital assets (e.g., metaverse real estate, brand partnerships, merch and token sales).
Assuming you are a digital artist, like Beeple, and you are using the blockchain as a platform to share and sell your individual digital artworks, your level of exposure is minimum (no need to read on :). However, if that is not the case, you may have murkier waters to navigate through and it’s important to read on so that you understand how to steer clear of the more obvious landmines.
In this article, I will provide a brief overview of what constitutes a ‘security’ under U.S. law. It is important to note that blockchain, crypto, and NFTs are relatively new concepts, which have yet to be thoroughly scrutinized by the courts and regulators. As such, the regulatory landscape is constantly evolving and the legal rules and assumptions described below may no longer be applicable by the time you read this article.
What makes an NFT a security?
In 1946, the U.S. Supreme Court (SEC V. Howey) created the test used to determine whether a transaction and/or instrument is a security. This test, which is still in use today, is called the Howey Test, and it favors substance over form, examining the actual substance of the instrument, rather than the label (or name) that it was given.
The Howey Test is composed of four prongs. It is important to note that the prongs are cumulative and in order for something to be classified as a ‘security’, all four prongs need to be met.
Let’s break them down and see how they may apply to NFTs:
1. “The investment of money” — this term was expanded, in later rulings following the Howey case, to cover any thing of value. As such, the purchase of an NFT with cryptocurrency (such as ETH or BTC) can certainly qualify.
2. “in a common enterprise” — the SEC noted that investments in digital assets have historically constituted ‘investments in a common enterprise’ “because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts.” NFTs are non-fungible, and sometimes carry unique rights for each token holder. While it is true that some NFTs, similarly to traditional works of art, may not amount to a ‘common enterprise’, a case-by-case analysis is required. For example, when a NFT is part of a series, the SEC (or a court) could find that its value is linked to the series as a whole, which may amount to a ‘common enterprise’.
3. “with a reasonable expectation of profit” — While a buyer may expect to realize the appreciation of a digital asset (i.e. NFT) through selling at a profit, on a secondary marketplace, the same might be true for traditional artworks, which aren’t typically considered securities. To satisfy this prong, the courts ruled (S.E.C. v. Joiner Corp.) that it is the offer itself, and the manner in which the NFT was promoted, that will determine if it gave cause to ‘a reasonable expectation of profit’ within the meaning of the Howey Test.
This, again, means that a case-by-case analysis of the project will be required. is also why NFT issuers and promoters should consult with a securities lawyer in advance, to review their marketing materials and roadmap and to avoid an inadvertent classification that their NFT may be deemed a ‘security’.
The pending class action against Dapper Labs emphasizes the complexity of this prong. Dapper were very careful in promoting NBA Top Shots, in their Service Terms of Use they even required users (i.e. buyers) to agree that they “are using NFTs primarily as objects of play and not for investment or speculative purposes”. Accordingly, the plaintiffs do not allege that Dapper promoted these NFTs as an investment contract. Rather, the plaintiffs allege that the investors who bought these NFTs bought them with the expectation of profit.
If this extreme interpretation of the Howey Test prong is accepted by the court as the new standard for qualifying as an ‘investment contract’, it will likely cause many (if not most) NFT projects to be classified as securities.
4. “to be derived from the efforts of others” — In The DAO Report, the SEC found that the tokens issued by Slock.it UG within the framework of it’s decentralized autonomous organization (DAO), qualifies for this prong of the Howey Test, as the issuers retained significant control over the project even after it was issued.
When it comes to NFT projects, however, the SEC’s focus is more likely to be on the level of the creator’s involvement in the continuous growth and value of the NFT project, post-mint.
What happens if my NFT is deemed a security under the Howey test?
There are various regulatory requirements that accompany the classification of an NFT project as a security.
First and foremost, disclosure and registration requirements apply, potentially skyrocketing the cost associated with the project’s launch. Registered securities are also subject to additional regulations, limiting their marketing and transfer (and in many cases, prohibiting hard forks and airdrops).
For most creators, such classification would render the project not financially viable.
In addition to the exposure faced by the creators, celebrities and influencers endorsing such NFT projects could face similar risks.
For example, in the Centra ICO case, the SEC settled charges against professional boxer Floyd Mayweather Jr. and music producer DJ Khaled, after they endorsed an ICO that was found to be an unregistered security offering.
To sum up, launching a successful [and legal] NFT project requires careful planning and consideration to make sure that the roadmap, tokenomics, and marketing materials do not trigger any securities laws classifications.
As the NFT community is growing and evolving, it would be wise for NFT projects to learn from the mistakes of their predecessors — the ICO projects. As new and exciting as the underlying technology may be, in many cases, it is still subject to the existing regulatory framework — regardless of whether its creators were aware of these laws or not.
