As jurisdictions adopt differing approaches to digital-asset regulation, U.S regulators pursue enforcement against NFT activities under existing securities law.
US NFT enforcement action
The U.S. Securities and Exchange Commission (“SEC”) has broadened its crypto asset enforcement to non-fungible tokens (“NFTs”) in charging Impact Theory LLC (“Impact Theory”) with allegedly conducting an unregistered offering of “securities” in the sale of their ‘Founders Key’ NFTs (“Key NFTs”). This action acts as a reminder for those doing business in Australia that, although there is no crypto-specific legislation here, existing laws might similarly apply to your NFT business.
Impact Theory is a California based Web3 media company, with a large social media following, that instituted the Founders Keys project with the stated goal of awarding purchasers with exclusive benefits such as ad-free content, free or discounted access to additional content and other ancillary perks. Each Key NFT was associated with a digital image, with randomly generated visual features. Impact Theory also received US$978,000 from a 10% “royalty” from secondary market sales, encoded in the underlying smart contracts. Impact Theory collected the funds raised from Key NFT sales in a single crypto asset wallet and used portions for the Impact Theory business.
The SEC alleged that from October to December 2021, Impact Theory offered and sold 13,921 Key NFTs, in total raising US$29.9 million, in breach of US securities laws relating to an unregistered offer of a security. The SEC alleged that the offer and sale of Key NFTs attracted US securities law because Impact Theory encouraged potential investors to view the purpose of the NFTs as an investment into the business, stating that investors would profit if Impact Theory was successful.
More specifically, in advance of the initial offering, Impact Theory instituted several marketing campaigns across social media and through live, online forums (particularly through the platform Discord). In relation to these events, the SEC was particularly concerned with the following alleged conduct:
- Synonymising purchase of the Key NFTs with investment in the Impact Theory business itself;
- Statements that investors could expect profits correlated to business success;
- Representations that the funds raised would be used for “development”, “bringing on more team” and “creating more projects”; and
- Statements made by actual and prospective buyers that demonstrated belief that purchase of Key NFT was similar or the same as investing in the company.
As detailed in orders released by the SEC on 28 August 2023, to avoid litigating the issue, Impact Theory agreed to (among other things):
- pay US$6.1 million (including a $500,000 civil penalty and also an amount in interest);
- destroy any remaining Key NFTs in the company’s possession;
- revise any code or smart contracts underlying the Key NFTs and remove the royalty scheme for any remaining Key NFTs; and
- assist the SEC in establishing a distribution plan to reimburse affected investors.
What does this mean for NFT issuers in Australia?
Financial services regulation
In Australia, the classification of products or assets as “financial products” determines the requirements on issuers and attracts the scope of the Corporations Act and ASIC’s enforcement jurisdiction. According to ASIC’s Information Sheet 225 on crypto assets, there are several types of “financial products” which may apply to any crypto asset (including NFTs), depending on the attached legal rights. In the case of Impact Theory, the SEC alleged that the representations made to investors that purchase of the Key NFTs were synonymous with investments in the business, and that investors would profit from the business’s success, which brought the offer and sale into the purview of the SEC on the basis that those sales constituted an investment contract under the U.S. Howey test. In Australia, this resembles (although is not entirely the same as) an “interest in a management investment scheme”, which requires:
- people contributing money or assets (such as crypto assets) to obtain an interest in a scheme;
- any of the contributions are pooled or used in common enterprise to produce financial benefits or interests in property, for purposes that include producing a financial benefit to contributors (e.g. an increase in the token value);
- the contributors do not have day-to-day control over the operation of the scheme.
The recent enforcement action taken by ASIC against Web3 Ventures Pty Ltd provides an insight into the way in which ASIC has been applying this test. In this case, ASIC alleges that Web3 Ventures (t/a Block Earner) impermissibly operated unregistered managed investment schemes in relation to several products as it allegedly allowed users to deposit AUD into their accounts which was then converted to crypto assets and pooled to earn a fixed or variable yield.
Although there has not yet been an enforcement action in Australia in relation to the sale of NFTs, the SEC’s approach to the Key NFT initial sales stands as a stark reminder that financial services regulations might still apply to your business regardless of the underlying technology (eg fungible tokens or NFTs) – it is the circumstances in which those products are offered for sale that is most relevant to the application of financial services regulations.
When doing business in Australia it is also important to be mindful of the prohibitions on making false or misleading statements whether in relation to financial products or not. For example, ASIC is currently pursuing charges against BPS Financial Pty Ltd for allegedly making false, misleading, or deceptive representations in relation to their crypto-asset token ‘Qoin’. A similar proceeding could be commenced by a regulator in relation to the sale of NFTs because, as explained above, Australian laws are designed to be technology agnostic. Accordingly, it is essential to ensure that any representations made regarding crypto asset related products or services (including NFTs) are not misleading and that there is a reasonable basis for any statements made during promotion and marketing.
There are several other laws that could also apply to issuers of NFTs in Australia. In each case, it is important to understand the product you are selling, how you intend to sell the product, and to also clearly identify any legal rights that might be attached to the product as these matters will be most important in identifying any existing laws that must be complied with.