As non-fungible tokens have soared in popularity in recent years, regulators have begun to question whether they should be classified as “securities.” The implications of this are far-reaching, giving the Securities and Exchange Commission (SEC) a role in regulating NFTs in the U.S.
While the SEC does have the authority in the United States to regulate NFTs as securities, at this time only projects that are used like traditional securities, such as to raise money, may come under its jurisdiction. One of the roles of the SEC is to protect investors. In the arena of NFTs and other digital assets, this is accomplished by ensuring that those assets are traded in a fair and regulated market.
So, what exactly is the debate about NFTs and the SEC? Is it a case of “big government” reaching too far? Do the regulations impinge on the rights of creators, owners, buyers, sellers, and even investors? There’s a lot to unpack in this controversy.
What is the controversy with NFT?
In a nutshell, the controversy over NFTs and the SEC revolves around whether or not NFTs are securities. If they are then that gives the SEC regulatory authority. If not, then the NFT arena is largely unregulated.
If NFTs aren’t securities, then what are they? Many proponents of NFTs claim that these types of digital assets are collectibles. They argue that because of this, they will not pass the Howey Test which would indeed classify them as securities. Mark Cuban and other supporters liken NFTs to high-tech trading cards. They are simply digital art or a collectible.
There are several instances where NFTs have ventured into some grey areas regarding investments. MetaKovan purchased several Beeple artworks totaling $2.2 million and placed them in a fractionalized investment fund. When Beeple’s famous “Everydays” artwork sold for millions, the sale drove up the value of the NFTs that MetaKovan owned. This does classify the NFT as a security.
In a similar situation, several investors pooled their money to purchase the Banksy artwork, “Morons” for $95,000. Once purchased, it was minted as an NFT, and the original, physical piece of art was intentionally burned so that only the token of the artwork remained. This drove the value of the token up to $380,000, giving the investors and buyers a very tidy profit.
These events clearly place NFTs directly in the classification of securities, it would seem.
The other issue centers around copyright law. The question is, who has the right to mint an NFT? Does the creator of the original work have those rights, or does the person who owns the work have those rights? This could potentially cut the original artist out of certain profits for the use of their work.
These controversies go on and on. It is going to take some time to sort it all out.
How is NFT defined according to the IRS?
The Internal Revenue Service (IRS) provides this definition of NFTs:
An NFT is a unique digital identifier that is recorded using distributed ledger technology and may be used to certify the authenticity and ownership of an associated right or asset. Ownership of an NFT may provide the holder a right with respect to a digital file (such as a digital image, digital music, a digital trading card, or a digital sports moment) that typically is separate from the NFT. Alternatively, NFT ownership may provide the holder a right with respect to an asset that is not a digital file, such as a right to attend a ticketed event or certify ownership of a physical item. For purposes of this notice, the right that an NFT provides or the ownership of an asset that an NFT certifies is referred to as the NFT’s associated right or asset.
Distributed ledger technology, such as blockchain technology, uses independent digital systems to record, share, and synchronize transactions, the details of which are recorded simultaneously on multiple nodes in a network. A token is an entry of data encoded on a distributed ledger. A distributed ledger can be used to identify ownership of both fungible tokens (such as cryptocurrency, as described in Rev. Rul. 2019-24, 2019-44 IRB 1004) and NFTs.
Should NFTs be considered securities?
There is no easy answer to this question. In 1946, the United States Supreme Court established the “Howey Test” to determine if an arrangement or asset can be classified as a type of security. In order to pass this test, the asset must meet four criteria. If it does, then it is considered an “investment contract” which makes it a security.
The four criteria of the Howey Test are:
- The asset must involve an investment of money
- The asset must be in a common enterprise
- There must be a reasonable expectation of profits from the asset
- Those profits must be derived from the efforts of others
At this point, NFTs are determined on a case-by-case basis, before they pass the Howey Test, the circumstances and facts of each specific NFT are scrutinized.
In other words, if an NFT is purchased, it would satisfy the first criteria. But if it is acquired for free, it would not.
A common enterprise, which is the second criterion, could be difficult to prove, especially if the unique work of digital art is represented by the NFT.
A “reasonable expectation of profits” can also be difficult to determine with NFTs. Digital collectibles, just like other collectibles such as baseball cards or books, may experience a surge in value, or they may lose value quickly. The reasons that this occurs typically have little, if any, to do with the person who controls the NFT. Those factors typically fall outside of their control or reach. Even the creator of the work may have little to no control over the value.
The fourth criterion of the Howey Test may prove difficult as well. Typically, the purchasers are the ones who generate interest in the token, not a marketing department or team. Because the purchasers are the ones promoting the NFT, it does not meet the “efforts of others” requirement.
The court or SEC answers these questions with each individual NFT. At this point, there is little more that they can do.
What is the SEC’s view on NFT?
In August 2023, the SEC charged Impact Theory, LLC for engaging in the offering of a security that was unregistered. This landmark case was the first time that the SEC flexed its regulatory muscle and penalized a company for failing to treat an NFT as a security.
SEC records show that Impact Theory offered and sold to investors what they called “Founder’s Keys” – these were three distinct types of NFTs. Prior to offering the Founder’s Keys, the company hosted live events and publicly posted about the tokens via the company’s websites, the Discord platform, and the company’s social media channels where they encouraged potential investors to consider token purchases as an investment in the company. They further stated that doing so would garner profits for those investors if the company was successful.
The SEC determined that, based on the statements made by Impact Theory, any and all investors, both potential and actual, reasonably believed that the NFTs they purchased were indeed investments and that those investments would appreciate in value.
In all, Impact Theory raised more than $29 million of the 13,921 NFTs that they sold to investors. There were NFTs that were traded on secondary markets after the initial offer and each secondary sale gave the company a 10% royalty.
The SEC charged Impact Theory with offering and selling unregistered securities. And they won. Impact Theory had several requirements per the SEC order:
- Within 10 days of the order, the company had to destroy any and all NFTs that were in its control or possession.
- The company had to publish a notice of the SEC order on its social media channels and all websites.
- The company had to eliminate all royalties by revising the smart contracts on all of the affected NFTs.
- The company had to distribute monetary relief to affected investors by paying a disgorgement of $5,120,718.27, $483,195.90 in interest, as well as a $500,000 penalty.
The Takeaway
The actions of the SEC thus far have provided some very important insight into its reach and authority regarding NFTs.
Can an NFT represent stock? As has been demonstrated, the answer is yes. We see it with the Impact Theory case and will certainly see it with future cases. These are largely uncharted waters so existing laws are being examined and amendments are being proposed. Some new laws are also emerging in order to directly address the issues of digital assets, including regulation, registration, classification, and ownership. There is still a long way to go.
Can the SEC regulate NFTs? Again, as we have seen, yes, they can. If the digital asset meets the criteria of the Howey Test, the SEC has the authority to step in and penalize companies and individuals who fail to register their NEFs as securities if they are treating them as investments.
Still, this begs the question, should the SEC (or some government agency) regulate NFTs in the US? Many say yes because there could be legal issues when it comes to ownership and authenticity. In these cases, some degree of government oversight of NFTs is important. It can stop many of the scams and schemes, making the NFT marketplace safer by providing protection to people who buy these digital assets.
The Impact Theory ruling has sparked a heated debate over whether NFTs are securities or collectibles as well as how much authority the SEC or any government entity should have regarding the tokens. While the SEC has issued a statement that “the facts and circumstances of a product” will be reviewed as opposed to looking at a label in order to identify it as a security.
This is where an NFT lawyer is invaluable. They can help you remain compliant by identifying which NFTs need to be registered and which do not. They can cut through complex laws and cases to determine what you need to do to stay on the right side of the law.
New York NFT Lawyer – Stay Compliant and Protect Yourself
If you are dealing with NFTs at any level, it is very easy to fall into non-compliance. You need a legal team that will stand up for you and protect your rights. You want an attorney who understands NFTs, who has a clear understanding of the laws surrounding NFTs, and who has the courtroom experience to go to bat for you when you need it.
You need The Litvak Law Firm.
Before you begin buying or selling NFTs, talk to us. We will help you make smart decisions and remain compliant. Whether you are a creator, buyer, seller, or investor, we can help you. Call 718-989-2908 today.