NFTs as Securities: A Review of Arkonis Capital’s Letter to the SEC

I list, for reference, the letter from Arkonis Capital’s parent company, Sustainable Holdings, here. I am pleased that Arkonis has brought the issue of whether an NFT is a security to the forefront in their letter to the SEC; I believe these are essential issues to be addressed to shed light on a potential grey area, particularly in the wake of the 2017 ICO craze. As an active participant in the NFT field, we seek to contribute our knowledge as much as possible to guide this field.

Regarding NeoWorlder, we operate in both the fungible and non-fungible token Arenas. Concerning the BUN, a cryptographic token, the following should be noted:

(a) It is a digital voucher that has intrinsic value only within our platform; similar to a game credit, it has a fixed price of 0.20 USDC and is used for services and as a bid unit in pay-per-bid Battle Bidding auctions (similar to the penny auction site, Quibids);

(b) We provide disclaimers on our website and all of our documentation (in particular, our Telegram group) to dispel any notion that those purchasing blockchain tokens expect secondary market listings, trading, and profits;

c) We have no token allocations for team members, advisors, third parties, or company reserves; our goal is to sell as many BUNs as possible and ensure they are used on our platform (which can then be recirculated back to us for resale);

(d) our product was operational from day one, and we have not accepted any investments before its launch and operation;

(e) our exit strategy is for us to migrate all centralized modules of our software to a decentralized autonomous organization (DAO) and then retire our company, receiving royalty-like revenues from the DAO as long as the platform is of value to our members;

(f) members can custodize BUNs themselves if they choose.

On this note, I remember that my data was hacked in the US healthcare breach a couple of years back and if I had been given the choice to hold the keys to my data (as an NFT) this could have been prevented; the technology exists to do this today and migrate from centralized solutions that act as honey pots.

For this reason, our members should be able to secure their BUNs. While it is not in our immediate commercial interest to have BUNs outside of our platform, we recognize that this is in the best interest of our members in the long run. Consequently, we have capped a member’s maximum amount of BUNs in their account (both in the Arena and off-site wallets) at 50,000 BUNs (or USD 10,000). We also have a policy of not promoting or addressing these matters, as people can misinterpret and distort our words; our focus is to run a sound business.

Thus, our use and utility of the BUN are not in question. Now, I turn to the matter brought forward by Arkonis: the application of the Howey Test to digital assets. From a legal perspective, this is a fascinating theoretical and real-world test for the SEC to unpack further. As Arkonis points out, the SEC stated, “The main issue in analyzing a digital asset under the Howey Test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others.”

To understand this, let us consider the case of an NFT representing the ownership of a unique artwork. It is non-fungible and achieves value in an asymmetric context (i.e., the NFT must be matched with a specific willing buyer, and its re-sale must seek a willing buyer similarly). For example, is the Beeple that sold for $69 million likely to find another buyer for that amount or more? It can be challenging to predict. However, in a highly liquid market of fungibles (like Bitcoin or the US dollar), it is possible to find a buyer of one Bitcoin for a generally assumed market price since one Bitcoin is the same as the other.

Hence, if artwork-related NFTs achieve a particular value, it is unlikely that someone else in the future is willing to pay for it (and this is likely, in the majority of cases, not to happen due to its non-fungibility), making the argument of an expectation of profit a bizarre contortion of reality. For this reason, I posit that there must be two types of NFTs:

(a) A right granted to its owner to expect an external profit inherently from the benefit of owning the NFT (for example, an NFT representing a legal right to oil production revenues for a particular plot of land). The NFT is tainted as a security based on that underlying grant.

(b) A right to, or actual ownership of, a creation that does not provide any expectation of revenues but that may be valued at a price that a willing purchaser will pay for it in the future.

We shall refer to these two types as “a” and “b” for simplicity.

Both types should not be confused. For instance, baseball card collectibles as NFTs and vintage cars as NFTs are not securities but creations treated as goods.

While I agree with the above statement, I think that Arkonis oversimplifies the matter when they write: “Fractionalized NFTs could be considered security… While NFTs are meant to be non-fungible, fractional NFTs that allow numerous purchasers to acquire a partial ownership interest in the NFT increase the likelihood the NFT could be deemed a security.” But, again, this ought to be nuanced.

For example, owners that have pooled their resources together (syndicated) to buy an asset in the expectation of profits, I believe, would meet the prongs of the Howey Test and be a security because of the scheme (for example, several such methods exist such as buying a share of a painting, a rare collectible, etc.). But, again, this has nothing to do with the NFT itself but rather a joint enterprise for profit (the NFT is merely the vehicle to achieve that aim).

From a blockchain perspective, this is like having fungible tokens that can be invested in to buy an NFT. Capital is raised by the fungible token sale in a scheme to buy a non-fungible pass. But if one person were to buy the NFT independent of the system, it cannot be secure unless it is a type of “a” NFT.

Furthermore, a person that collects a set of individual NFTs and combines them to sell as a pack for a higher price (by definition fractionalized, in reverse) should not be a security (unless a type “a” NFT). This is like combining an orange, a strawberry, and an apple to make a fruit pack whose value by default would be expected to be higher as (a) it combines three products, each having a singular value, and (b) it becomes more desirable to a willing purchaser because of the variety of fruits offered in the pack.

It is interesting that Arkonis also notes the SEC’s following remarks:

“Price 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. However, this does not apply to Type “b” NFTs, which deal with the marketability of a unique creation, which is not affected by external market forces but rather by desirability in the eyes of the beholder.”

I find this quote to be pertinent but ill-suited to apply to type “b” NFTs because the latter deals with finding a market for a unique creation, which is not affected by external market forces but rather one driven by desirability in the eye of the beholder (i.e., if someone wants to buy a Banksi, these external market forces generally will not apply).

Lastly, it should be obvious by now that at scale, finding the right buyer and seller is not like going through an order book for fungible tokens on Binance. It is only achievable through an auction process. Thus, auction houses are the NFT “exchanges” much like the Binance’s or Uniswap’s are exchanges in the fungible tokens sector. However, this is where the analogy ends as they are both extremely different in how they operate their compliance obligations, although it is possible to have an NFT securities exchange for type “a” NFTs.

If an auction house deals with a type “b” NFT, we posit that it shouldn’t be a security, and therefore would automatically fall outside of the legislative ambits to be licensed as a securities exchange. Baseball card swaps online platforms, E-Bay, and Craigslist are not securities exchanges.

It, therefore, falls upon the particular nature of an NFT and the rights appurtenant thereto to classify whether or not this is a dealing in securities. It would most certainly be the case that if an NFT is inherently tied to profit sharing rights, rental income for, say, a room in a building, or mineral rights for specific lots to say a few, then this would be a security and their sale or trade would fall under the ambit of securities law.

If it is a baseball card, art work, or a sculpture (all complete and finished products) then it would turn the definition of securities on its head through mind-boggling acrobatics.

In Loot NFT’s specific case, we work with creators that produce finished products that we sell on consignment (or after having purchased same from them outright) in an auction. We also allow NFTs obtained on our site to be sold by their owner in the same manner. In both cases, the owner must contract out with us to list, pass KYC and background checks, and sell the item.

The gamified elements we introduce drive participation and the desirability in such creations, much like Christie’s would seek to market an item to as many auction participants as possible. To note, no NFTs we list inherently grant a right to obtain a revenue, an income, or a profit.

While the above is the rationale, Loot NFT will of course be very attentive to the words of the regulators for our internal compliance.

The above is not legal advice, it is my humble take on the matter and doesn’t represent the views of Loot NFT Co LLC.