SEC’s Move On NFTs Continues Pattern Of Case-by-Case Regulation – Fin Tech

Last week, the SEC filed its first ever enforcement action on
non-fungible tokens, charging a media and entertainment company
with conducting an unregistered sale of NFTs called
“Founder’s Keys.”

Although the issuer, Impact Theory, immediately settled the
enforcement action, the SEC’s apparent determination to
regulate digital assets beyond cryptocurrency may raise a thorny
precedent.

‘The Next Disney’

In late 2021, Impact Theory offered to the public three tiers of
its Founder’s Key NFTs—Relentless, Heroic, and
Legendary—sold at escalating prices. Impact Theory, which
advertised it was “trying to build the next Disney,”
wasn’t modest about the potential “tremendous value”
of these NFTs and equated them to “g[etting] in on Disney when
they were doing Steamboat Willie.” By December 2021, Impact
Theory had raised almost $30 million worth of ether through its
Founder’s Key offerings.

In a divided order issued on Aug. 28, the SEC instituted and
simultaneously settled cease-and-desist proceedings against Impact
Theory. For the first time in an enforcement action, the SEC took
the position that NFTs constitute securities, such that Impact
Theory’s failure to register its Founder’s Keys violated
the Securities Act of 1933.

In addition to paying $6.1 million in disgorgement, penalties,
and interest, Impact Theory undertook to destroy all Founder’s
Keys in its possession and to rewrite the smart contracts
underlying the Founder’s Keys to eliminate any royalties it
might receive from secondary market transactions. Impact Theory
didn’t admit or deny the SEC’s findings.

Collectible or Security?

In its unprecedented move against NFTs, the SEC continued its
practice of quilting a patchwork crypto policy through individual
enforcement actions rather than clear-cut regulations.

The SEC again applied the 1946 test laid out by the Supreme
Court in SEC v. W.J. Howey to determine
whether a specific type of digital asset—here,
NFTs—constitute securities that fall within the SEC’s
purview.

According to the Howey test, an asset is an
“investment contract”—and therefore a
security—if it requires an investment of money; in a common
enterprise; with the expectation of profit; and to be derived from
the efforts of others. Assets that don’t qualify as securities
under the Howey test are classified as commodities.

In characterizing the Founder’s Keys as securities, the SEC
primarily focused on Impact Theory’s public statements inviting
potential purchasers to view themselves as investors.

To that end, Impact Theory repeatedly shared its view that the
fortunes of NFT purchasers were tied up with the company’s
success, calling the Founder’s Keys “the mechanism by
which communities will be able to capture economic value from the
growth of the company that they support.” Moreover, the
proceeds were used to develop the company with a view toward
delivering value to NFT purchasers.

But not all commissioners were swayed by this logic. In a dissenting statement, Hester Peirce and Mark
Uyeda questioned the applicability of the Howey test to
NFTs, which “were not shares of a company and did not generate
any type of dividend for the purchasers.”

Instead, according to Peirce and Uyeda, the Founder’s Shares
were more akin to “watches, paintings, or collectibles”
where the seller makes vague promises to build the brand and
increase the resale value of the tangible commodities.

Looking Forward

The SEC’s expansion of its jurisdiction to NFTs is
unsurprising. When it relaunched its cyber unit as the Crypto Assets and Cyber Unit in May 2022, the
SEC specifically identified NFTs as a focus of its new unit.

And in February 2023, NFT sales formed the basis of a federal
insider trading prosecution against digital marketplace OpenSea and
its founder, Nathaniel Chastain.

That said, it’s unclear whether the commission intends to
set a new precedent for treating NFTs as securities, or whether
Impact Theory is simply a case decided on its specific facts.
Although the dissent characterizes the facts underlying the NFT
offering as “unremarkable,” Impact Theory’s
management specifically touted the investment aspects of the
Founder’s Keys early and often.

More importantly, the SEC’s opinion won’t be the final
word on the issue. If the SEC continues its
regulation-by-enforcement strategy, the question of whether NFTs
are securities is one that ultimately will be decided by the
courts.

So far, court rulings on digital assets have been all over the
map. In July, US District Judge Analisa Torres held that
Ripple’s XRP token wasn’t a security when sold on public
exchanges (as opposed to institutional investors)—a decision
seemingly headed for an interlocutory appeal to the Second
Circuit.

A few months earlier, US District Judge Victor Marrero held that
basketball-focused “Top Shot” NFTs did qualify as
investment contracts under Howey in the context of a
securities class action.

Until the courts have their final say on the issue, or the SEC
puts pen to paper on formal regulations, the SEC likely will keep
NFTs in its crosshairs and apply federal securities laws to NFT
offerings in appropriate cases.

NFT creators who don’t wish to register their tokens as
securities should promote NFTs as collectibles and avoid making
claims that explicitly link their future value to the issuer’s
success.

Reproduced with permission. Published September 7, 2023.
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