First NFT Crackdown Signals SEC Revving Up Enforcement Efforts

US securities regulators’ settlement with a Los Angeles media and entertainment company opens a new front in their clampdown on crypto products, while raising questions about how financial watchdogs view other non-fungible tokens.

The Securities and Exchange Commission last week said it settled with Impact Theory LLC over charges the company conducted an unregistered securities offering when it sold almost $30 million worth of NFTs.

The SEC has been aggressive in its efforts to police crypto markets. The action against Impact Theory, the agency’s first over NFTs, widens the SEC’s sweep over products it views as securities. Industry attorneys expect the SEC to bring more NFT enforcement actions soon.

“I think what the SEC is trying to do is build out the guide rails of how the rules apply to NFTs by simply dropping enforcement actions, rather than going through customary regulatory procedures,” said Andy Lee, an attorney at Foley & Lardner LLP who helps to lead the firm’s Digital Assets, Web3, & NFT practice area. “I think you’re going to see more in the next couple months.”

‘Stake in the Ground’

NFTs can be used to prove ownership of different assets, like works of art or sports memorabilia. The tokens’ popularity exploded in 2021, when Christie’s sold an NFT artwork for $69 million, sports teams launched NFT collections, and musicians sold album as NFTs.

It was amid that craze that Impact Theory launched a sale of NFTs, known as Founder’s Keys.

The company, which said it was trying to be the next Disney, sold NFTs with different combinations of symbols. Buyers got access to perks including live events, and were told they’d profit if Impact Theory was successful, the SEC said. Impact Theory also said it would use money from the sale to help build the business, the agency said.

The case raises difficult questions, the SEC’s two Republican commissioners said.

The SEC doesn’t “routinely bring enforcement actions against people that sell watches, paintings, or collectibles along with vague promises to build the brand and thus increase the resale value of those tangible items,” the commissioners, Hester Peirce and Mark Uyeda, said in dissenting from the agency’s action.

The SEC has been scrutinizing NFT creators since at least last year. Yuga Labs Inc., the creator of the popular Bored Ape Yacht Club collection, was among those under investigation, Bloomberg reported in October 2022. The SEC hasn’t sued Yuga.

The SEC’s settlement with Impact Theory is “putting a stake in the ground in the NFT territory,” said Baker & McKenzie LLP attorney David Zaslowsky, who has worked on several disputes involving blockchain.

Impact Theory said in a statement it was happy to have concluded the SEC’s investigation.

“Although we are disappointed that the SEC has chosen to broadly question the exciting technical innovations that make digital assets possible through the lens of the securities laws, we remain optimistic for the future of this industry in the United States and hope we remain the global home of innovation,” it said.

NFTs as Securities

The SEC has been dealt recent setbacks in court over its regulation of digital assets. Last week, the US Court of Appeals for the DC Circuit overturned the agency’s decision to block Grayscale Investments LLC’s proposed spot Bitcoin exchange-traded fund.

Still, the SEC isn’t alone in taking the position that NFTs can be securities.

State securities regulators, including those in Texas, accused Republic of Georgia-based Slotie NFT in October 2022 of violating their securities laws by selling NFTs to raise money for metaverse casinos. States brought similar actions against Flamingo Casino Club and Sand Vegas Casino Club.

Private buyers have also sued Dapper Labs—the creator of the National Basketball Association’s Top Shot NFTs—and sports-betting firm DraftKings Inc., alleging the companies sold unregistered securities. In February, a federal judge allowed the suit against Dapper Labs to proceed, ruling the buyers adequately alleged that the NFTs at issue are securities.

The SEC’s “enforcement action, as reflected in the settlement, and the civil decision in Friel v. Dapper Labs heightens the importance of understanding the circumstances that could require registration under the federal securities laws,” said Venable LLP attorney Xochitl Strohbehn, who defends clients in securities and crypto litigation.

The SEC didn’t go far out on a limb with its action against Impact Theory, Eversheds Sutherland (US) LLP securities attorney Adam Pollet said.

The case is similar to other actions the agency has brought over initial coin offerings involving the sale of cryptocurrencies, attorneys said, noting the common allegations of a centralized promoter selling assets as an investment in a business.

“You can see how this fits in nicely with the other cases that the staff has previously brought relating to digital assets,” Pollet said.

Potential ‘Sea Change’

It’s difficult to read how the SEC views other NFTs, attorneys say.

Much of the NFT space is about artwork and music, Zaslowsky said. A dedicated NFT art scene has emerged, while musicians like Canadian singer-songwriter Grimes have sold songs and music as NFTs. Brands like Adidas AG have also partnered with digital artists for projects.

“If the SEC starts going after them then it’s a big deal,” Zaslowsky said, referring to NFT creators in the art and music space. “Then it’s a sea change.”

Others worry that door is open. The Republican commissioners noted the facts in the SEC’s action against Impact Theory were “unremarkable,” with no allegations of fraud or other wrongdoing by the media company.

William Pao, chair of the Fintech Group at O’Melveny & Myers LLP, said it’s unclear which NFTs the SEC wouldn’t consider a security. It can be hard to draw a clear line between raising money as capital and selling a product, then using the proceeds to expand a business, he said.

“I think this action really muddies the water more than ever, to the point where every NFT issuer has to at least wonder whether the SEC will come calling,” Pao said.

The SEC’s emphasis on statements Impact Theory made about its NFTs underscores that regulators are closely watching how NFTs and other digital assets are promoted. Touting the tokens as a way to make money could attract regulators’ attention.

“The SEC views those kinds of statements as marketing in a securities sense—that it’s marketing it as an investment,” Lee of Foley & Lardner said. From “a risk perspective, it’s very important to stay away from that kind of language and focus instead on the utility of the NFT,” he added.

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