Non-fungible tokens, or NFTs, are a fairly new technology that is steeped in controversy. While many of the arguments center around intellectual property rights and environmental concerns, regulations remain at the top of the list. Currently, there are no adequate laws to fully protect NFTs’ creators, owners, and traders, leaving the industry open to a great deal of fraud, theft, scams, and schemes.
At the heart of the debates, lies the overarching question, “Are NFTs art, securities, or both?” Unfortunately, the answer is not straightforward, leaving lawmakers to find not only ways to regulate and oversee NFTs but also to find viable definitions that will guide the creation of new laws and modifications of old ones to make the NFT marketplace a safe space for all.
Understanding NFTs requires having a clear picture of what they are and how they are used, particularly in the financial arena. NFTs are not a currency like crypto is. They cannot be used as money because each token is unique. No two are the same. So, where do NFTs fit in the art world? How can they be securities? Are they all one or the other? Why is this debate important?
Here’s what you need to know.
Are NFTs art?
NFTs are digital assets. They can be sold. They can be bought. They can be collected. In fact, they are exactly like any other property or object with the exception of being a wholly unique object that happens to be intangible – it exists solely within a virtual framework. They are traded, sold, and bought exclusively within the metaverse.
You can’t put your hands on an NFT like you can a physical work of art. You can’t hang it on your wall or display it on your coffee table. It exists in your electronic devices and nowhere else. However, even though they do not fit the definition of “art” in the traditional sense, they have found a place in the art world.
NFT is digital art that has been tokenized in the blockchain. While it does not seem to bear much resemblance to physical art, the similarities are there.
- It’s original
- It can be copied, but the value is held in the original
- It’s collected
- The value is based on factors similar to those of physical art
So, what makes NFTs art? The same things that make physical visual objects art. The people who appreciate and collect them because that is how their value is derived. A human being views something and places value on it as an art form. It’s really that simple.
The problem is that while physical art is protected by certain laws, NFT laws still have to catch up with art that only exists on the metaverse.
Are NFTs securities?
Not all NFTs are considered to be securities, but the US Securities and Exchange Commission, SEC, entered the picture to address some that are being treated as what the Commission deems securities. There are legal definitions in place to determine what is security and what is not. According to the SEC, at least some NFTs fall into the category of securities.
The SEC sees NFTs as vehicles for certifying ownership and authenticity of an associated asset or right. They are digital identifiers that are unique and binding. In some cases, the NFT grants its holder or owner access or rights to a separate digital file. In some cases, it can give the holder ownership or access rights to a physical item.
The Howey Analysis is used to determine if something is a security. There are some NFTs that do indeed meet the criteria set forth by the Howey Analysis, which are:
- There was an investment of money involved in the trade, sale, or acquisition of the NFT.
- There was a common enterprise, meaning that there were two or more people who worked on the NFT project sale, acquisition, or trade.
- Those involved expected the NFT investment to generate a profit.
- The profits expected from the sale, acquisition, or trade of the NFT were derived from the efforts of separate individuals, such as artists who created the tokens.
Just because an NFT has the potential to increase its value does not make it a security. It must pass the Howey Test and many of them have done just that. This increases regulations for those particular assets and the SEC has already moved to prosecute companies that inappropriately handle or trade NFTs.
What is the difference between security tokens, utility tokens, and NFTs?
Blockchain tech and crypto have dramatically altered the management and perception of digital assets. Three key players, security tokens, utility tokens, and NFTs, work together within this realm and redefine securities and assets.
Security tokens – These are attached to a tradable asset such as real estate or shares in a company and represent ownership of that asset. Security tokens are typically regulated by securities laws.
Utility tokens – These are not investments themselves but instead are tools for facilitating interaction in a trade by providing access to a particular service or product that exists within a blockchain.
NFTs – These are digital tokens that represent unique digital assets that can’t be replicated. They cannot be used as currency but can be bought, sold, and traded for profit.
Each of these is subject to certain regulatory and compliance requirements. Security tokens are strictly regulated while utility tokens exist somewhere in the grey areas of regulatory oversight. NFTs have few regulations at this time, but that is evolving as lawmakers work to address known issues with NFT fraud and increase regulations designed to protect investors and increase security in the marketplace.
When does an NFT become a security?
When an NFT meets all the criteria of the Howey Analysis it is then deemed to be a security. The case that established this occurred long before the ideas of NFTs and cryptocurrency were even a flicker in someone’s imagination. The 1946 landmark Supreme Court case, SECURITIES AND EXCHANGE COMMISSION v. W. J. HOWEY CO. et al., 328 U.S. 293 established the current standard for how certain economic arrangements are determined to be classified as securities, or “investment contracts.”
In August 2023, The SEC brought charges against Impact Theory, LLC, finding that the company was guilty of engaging in the unregistered offering of a security. The three different NFTs that Impact Theory offered and sold were deemed to be securities because they were presented as investments that would result in profits. The SEC lined up the NFTs with the Howey Analysis:
- Impact Theory NFTs were purchased by investors using Ethereum.
- There was a “common enterprise” because there was a link between the fortunes of Impact Theory, its founders, and the investors.
- The investors had expectations of making a profit because of the way that Impact Theory presented the NFTs.
While this seems straightforward on the surface, critics have found several refutations and have made known their disagreement. Many question the validity of using the Howey Analysis and argue that the SEC does not typically charge individuals who sell collectibles or paintings even though they do make statements that indicate an increase in resale value.
How can you tell if an NFT is a security?
Determining which NFTs are securities, and which are not is a complex issue. When the popularity of NFTs was just emerging, it was never considered that they could be securities. It is generally advised that unless the classification of security is desirable and intentional for an NFT, it should be avoided. It is vital to examine the features of an NFT before its launch.
For instance, fractionalized NFTs can quietly slip into that area because the fractions can begin to resemble fungible tokens. This would classify it as a security or a collective investment.
Another telltale sign is its profit potential. An NFT that gives a person revenues or income could be classified as a security. However, it’s not just income that is the issue. If the income type that is offered is passive, that is what you should steer clear of. One way to get around it is to offer something on the native platform of the NFT. At that point, the revenue aspect becomes compensation instead of profit and that could get around the classification as a security.
A company that deals with NFTs and participates in governance could inadvertently push the NFT into a securities classification. In other words, a company that involves stockholders in business decisions – voting on governance – could be a factor in getting the SEC involved.
Why is the NFTs as an art or security debate important?
The debate over whether NFTs are art or security has serious implications in several areas. It has the potential to dramatically alter currently held notions regarding both art and securities. In fact, it is already changing the parameters of what constitutes art and redefined collectibles as well as the underlying motivation for investing in certain forms of “art.”
On the securities side of the debate, it is causing the SEC and other regulatory agencies to take a closer look at not just assets that could be deemed securities, but also at the criteria used to define securities. Some language seems to be rather loose, leaving room for broad interpretations.
Finally, the debate is forcing lawmakers to move on to creating laws and regulations to protect creators, owners, and buyers. There is a lot of controversy surrounding intellectual property rights and NFTs with the current climate leaving a lot of room for fraud and theft to occur. More effective regulations and requirements can lead to a safer marketplace.
These are not issues that will be resolved overnight – or likely in the near future. While the federal and state authorities are making strides to get some laws in place, it will still take time to get them passed and implemented. In the meantime, owners, buyers, and traders of NFTs need to take the appropriate steps to protect themselves against scammers, thieves, and those who seek to defraud them. It is important to remain vigilant and wary because the current laws are simply not enough.
Experienced New York NFT Attorney
If you are an NFT trader, buyer, or creator and are facing charges dealing with the SEC, you need an attorney who understands the industry and knows how to navigate the court system. You need a legal team that is knowledgeable in NFTs that will fight for your rights.
You need the Litvak Law Firm.
Call today to make an appointment with one of our NFT lawyers and get the help that you need. We’ll meet with you and go over your case then discuss the next steps and devise a plan of action so you have the legal help that you need and stay in compliance with the rapidly changing rules regarding NFT.
Don’t try to do it yourself. Call today at 718-989-2908.