Who Knew that NFTs Are the Regulatory Disinfectant We Need Right Now?, by Hermine Wong – Yale Journal on Regulation

Supreme Court Justice Brandeis once wrote: “[S]unlight is said to be the best of disinfectants.” As applied to our administrative state, our government best serves the public when it operates in the open. Transparency through public notice of meetings and public participation in the regulatory process is our best tool to hold our public officials accountable. However, what remains underdiscussed is how much “regulation by enforcement” undermines this fundamental principle of good government transparency. Another way to frame this is that “regulation by enforcement” deprives the public of its right to participate. This problem is particularly acute when the slow-moving administrative state collides with the speed of emerging technologies.

During Republican administrations, Democratic members of Congress often lambast presidentially-appointed agency heads for unilaterally curtailing regulations without affording public participation, see e.g., Cortez Masto, Colleagues Demand Transparency, Public Input for Oil and Gas Leasing on Public Lands. This makes obvious sense. Regulations govern nearly every facet of our lives, impacting our conduct, environment, businesses, access, health, and education. Without public input, it is impossible for bureaucrats in Washington, DC to anticipate every potential consequence that a regulation may have on a diverse and affected population. Nullifying a regulation upon which people have relied should trigger a comprehensive regulatory analysis that considers the input of all affected stakeholders.

Of equal importance, however, should be our vigilance against agency heads who prefer “regulation by enforcement” over the rigorous work of rulemaking. This “regulation by enforcement” approach similarly deprives the public of its right to participate in its own regulatory landscape. Instead of proposing regulations for public review and comment, regulatory agencies opt to file lawsuits against individuals, alleging violations of laws or regulations that have not been publicly disclosed. These individuals are blindsided by interpretations of the law never previously communicated by the agency. Rather than benefiting from a well-considered regulatory framework that analyzes interpretations, trade-offs, externalities, and consequences, the individuals are simply informed that they have broken the law. Their options are (1) to engage in costly legal battles to challenge the regulatory overreach or (2) to settle, pay less-costly-than-litigation fines, and cease their previously lawful activities.

Consider the disproportionate chilling effect this must have on small, first-time businesses.

Case Study: The SEC v. NFTs

For an illustrative example of this approach, one need look no further than the recent NFT (non-fungible tokens) enforcement actions taken by the US Securities and Exchange Commission (SEC). See Impact Theory and Stoner Cats

In the past two weeks, the SEC charged two distinct NFT projects with violating securities laws, and simultaneously announced their settlements with those projects. This development is concerning on at least two fronts. First, there is the SEC’s claim that the NFT projects should have considered themselves to be stocks of an IPO but didn’t. This is concerning because there are no SEC regulations governing NFTs. Second, while the SEC was quick to announce the settlement orders, it provided no accompanying guidance for legitimate NFT projects seeking to avoid violations of securities laws. The SEC is implying that it views all NFTs as stocks, but without regulatory grounding or guidance.

It is important to acknowledge that the two cases are very different. The facts in the Impact Theory settlement order, which was the first NFT case, are very bad. They read like a checklist of red flags taken directly from SEC’s own investor protection website. Considering that the defendants themselves agreed to the facts in the settlement order should give us confidence that this is exactly the kind of bad actor we want the SEC to pursue.  

However, there are two items of note that should also give us some pause about the SEC’s strategy.  First, despite the wildly fraudulent behavior stipulated in the settlement order, the SEC chose not to charge Impact Theory with fraud. The two dissenting SEC commissioners also share this concern.  Second, and relatedly, when the SEC charged Impact Theory with an unregistered offering, their word choice was that it was an “unregistered offering of NFTs,” as opposed to the “unregistered offering of securities.” This word choice tips the SEC’s hand that it believes that NFTs are synonymous with securities. But Congress has never given the SEC that authority. After priming the news cycle for a week with its first NFT enforcement action, the SEC followed up with a much more challenging NFT case: Stoner Cats.

To review, Stoner Cats is an animated series about an elderly woman who “uses medical marijuana to alleviate her early Alzheimer’s symptoms and her beautiful family of cats [who become sentient and] will do literally anything to save her.” The SEC charged the Stoner Cats creators with violating securities laws when they created NFTs to fund the production of the series because: 

  • They sold the NFTs at a fixed price (0.35 ETH). (Para 15)
  • Buyers could buy as many NFTs as they wanted. (Para 15)
  • The proceeds were used to pay the people who worked on the project (e.g., actors, writers, animators, web designers, computer programmers) (Para 16)
  • Owners of the NFTs would have (1) access to the Stoner Cats web series, (2) access to the Stoner Cats online community, which included opportunities to engage directly with the creators, (3) the option to sell their NFTs. (Para 18)
  • The creators engaged in a social media campaign to promote their project. (Para 18)
  • The creators emphasized the credentials of its team, which included Hollywood stars such as Mila Kunis, Jane Fonda, and Chris Rock, as well as technical expertise of other successful NFT endeavors, such as CryptoKitties. (Para 19)
  • The creators would receive 2.5% royalties for each resale of their NFTs. (Para 10)

Notably, none of the facts in the Stoner Cats settlement order suggest fraud, unlike the earlier Impact Theory case. And it is on these facts that the SEC charged the Stoner Cats team for violating the securities laws because their project should have been treated as an IPO. No different from the stock the public buys in Apple, Disney, and Ford.

But that isn’t actually true. 

Recall that the SEC oversees the securities markets. Those are the Apple, Disney, and Ford stocks that we buy. But when we buy those stocks, we don’t get an iPhone, or lifetime membership to Disneyland, or an F-150. This is because the SEC was created in response to the Great Depression, when scam artists sold stocks to the public worth nothing more than the paper those stocks were printed on. Note how fundamentally different this is from the NFT transaction here. According to the SEC’s own administrative order, the StonerCats creators at the time of the initial sale told people they were getting access to the Stoner Cats web series and the Stoner Cats community by buying the NFT. What they didn’t do was lie about what they were selling, or offer nothing for the NFTs aside from hype.  

Now we know that the SEC does not regulate the general entertainment industry.  Neither The Flintstones nor The Simpsons have registered as securities with the SEC.  So what makes this animated series different?  Unfortunately, we don’t know because the SEC has never issued a regulation on the issue, and so the public does not have the benefit of any analysis from them.  What we do know is that if the creators, writers, actors were all employees of a major studio, and the studio distributed some of the funds to those who worked on the show while keeping the remainder of the funds to itself, that would not be a violation of the securities laws. Because that is the current state.  

Could NFT-Rulemaking Have Solved the Hollywood Strikes? 

However, imagine if rather than pursuing these two NFT enforcement actions, the SEC had opened up their regulatory process to public comment and issued a proposed rulemaking to regulate NFT projects like stocks. The SEC would have had to be transparent with the public about how they analyzed the costs of their rule, articulate their rationale, and justify their interpretation of the laws. In addition to complying with the Administrative Procedure Act, the SEC has heightened operational rules that require this public analysis, see e.g., “An economic analysis of a proposed regulatory action compares the current state of the world, including the problem that the rule is designed to address, to the expected state of the world with the proposed regulation (or regulatory alternatives) in effect.” 

Here are some questions we would probably have an answer to:

  • Is it possible to program royalties distributions to the original artists and creators without violating the securities laws? You could imagine that all 171,000 striking writers, actors, artists in Hollywood right now might have a perspective to share because they are striking on the very issue of getting paid for their creations. Much like the royalties structure built into the Stoner Cats NFTs. 
  • How does the SEC balance the cost of the IPO registration process for small NFT projects? The cost of an IPO for even the smallest companies ranges from $2.1million – $12.9million. It is worth remembering here that all the Stoner Cats NFTs combined sold for a grand total of $8.2 million. (Para 14)
  • What should the ongoing disclosure requirements be for an NFT project once the sale and the project is complete? Once those are complete, the creative team behind the project has nothing left to maintain. Just like I’ve used up my Taylor Swift concert ticket and attended the concert. Should Taylor Swift provide me with ongoing disclosures after the concert in the same way that Apple provides me quarterly and annual disclosures for the stock I purchased on NASDAQ? And considering that all the money from the NFT sales have already been used to pay the creators, where should the money come from to make these ongoing disclosures?

Unfortunately, “regulation by enforcement” lacks public participation. The public is left without answers to any of these questions, just guesses about who an agency might enforce against next.

Let There Be Light

“Regulation by enforcement” is generally considered a dirty word, and it should be. It is the enforcement of laws without public notice or public participation, a strategy often employed by those who abuse their power. When confronted with fast-innovating emerging technologies, agencies may be tempted to pursue a “regulation by enforcement” strategy because the rigor of rulemaking seems too slow. However, by moving too quickly without public participation, those members of the public with the fewest means to litigate and who are in the greatest need of having their voices heard, will often be the first to be silenced. In those moments, agencies would be wise to recall President Wilson’s words, who was the president to appoint Justice Brandeis to the Supreme Court: 

“Light is the only thing that can sweeten our political atmosphere — light thrown upon every detail of administration in the departments; light diffused through every passage of policy; light blazed full upon every feature of legislation; light that can penetrate every recess or corner in which any intrigue might hide; light that will open to view the innermost chambers of government, drive away all darkness from the treasury vaults.” 

Hermine Wong is the Founder and Principal of herminewong.xyz, a firm that provides regulatory and political advisory services to emerging technology clients. She was previously the Head of Policy at Coinbase. Before that, she served as an attorney at the Securities and Exchange Commission, the Office of Management and Budget (OMB), OIRA (the Office of Information and Regulatory Affairs), and the State Department.

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