This past August, the US Securities and Exchange Commission took enforcement action against Impact Theory, a US media company that sold NFTs called “KeyNFTs.” It filed a second enforcement action shortly thereafter, against Stoner Cats, the creator of the online animated series “Stoner Cats.” In doing so, the SEC is indicating that, if particular features exist, the authorities may deem these tokens securities.
As known, NFTs, or non-fungible tokens, are unique tokens stored on various blockchain networks. People can use them for a wide variety of uses, such as:
- Proof of ownership of digital assets.
- Video game characters.
- Loyalty programs.
- Concert tickets.
- Link to show ownership of tangible items in the physical world, and more.
As such, authorities should not consider them securities. However, the SEC apparently thinks otherwise, and its actions indicate a growing interest in regulating NFTs.
Tokens and Investment Contracts
In both actions, the SEC argued that the NFTs offered and sold by the companies fall under the definition of “investment contracts,” which are considered securities under US law according to the Howey test. The SEC focused primarily on marketing campaigns and public statements (on YouTube, Discord, Telegram, etc.) forwarded by the project managers to their buyers, which created an expectation that the value of the tokens would increase based on the project’s success and the company’s efforts.
Therefore, the SEC argued, those NFTs fall under the definition of “security.” The SEC based its argument on the companies’ statements that they would use the profits from the sale of tokens for development, expansion of the team, and the creation of additional projects, and on the existence of a secondary market and a royalty model, i.e., the companies created a financing model for the project similar to fundraising through the issuance of securities.
Artistic Freedom or a Violation of the Law?
Two SEC commissioners, Hester M. Peirce and Mark T. Uyeda, have expressed concern about the regulatory developments in the field of NFTs. Their position is indicative of the disagreements among SEC officials regarding NFT regulation. The two commissioners argued that the SEC does not routinely bring enforcement actions against people that sell tangible items, such as watches, paintings, or collectibles, along with vague promises to build the brand and thus increase the resale value of those tangible items, because these are not the kinds of promises that form an investment contract. Peirce and Uyeda added that the SEC should provide clear guidelines about what is and is not permissible when issuing NFTs instead of initiating arbitrary enforcement actions. They opined that the SEC’s actions are contributing to the legal ambiguity faced by artists, writers, musicians, filmmakers, and others experimenting with NFTs as a way to build their fan communities.
The enforcement actions taken against Impact Theory and Stoner Cats are continuing the SEC’s regulation by enforcement stance and raise important questions about the regulation of NFTs. The SEC has not yet provided clear guidance on how it will decide whether or not a particular NFT is a security. However, it is clear the SEC is focusing on NFTs being offered and sold “with the expectation of profits from the efforts of others,” a principle that is an important component of the Howey test for determining whether a token is a security.
The Israeli Angle
Following the Israel Securities Authority’s proposal to apply securities laws to digital assets, it is not inconceivable that particular NFT projects will fall under the definition of “securities” in Israel too. Although the draft bill excludes NFTs from the definition of a “digital investment asset,” this exclusion does not mean that a particular NFT will not fall under the definition of “security.”