September 19, 2022 – Entry 1002: Are NFTs Securities?
Introduction
A little while ago I was working with a group of entrepreneurs who were starting a new business. This company was very cutting edge and wanted to utilize non-fungible tokens (“NFTs”) in several aspects of their business. One idea that came up was that utilizing NFTs to raise capital for the business would allow the company to sidestep the Securities and Exchange Commission (the “SEC”) and offer their investment opportunity to the world.
Raising capital for a business is typically done by selling securities, which are tradeable financial assets like notes, stocks, bonds, and investment contracts. The sale of securities is regulated by the SEC and state regulators and is typically subject to the bureaucratic red tape that these agencies are famous for. If selling NFTs was a way to avoid all of that, they could be incredibly useful for raising capital in nontraditional ways.
The question arose, is an NFT a security? Like all good legal questions, the answer is, it depends.
What’s an NFT?
A Nonfungible Token is a digital asset that represents a physical or intangible object like art or music. NFTs exist on the blockchain and have a digital signature that makes each one unique, hence nonfungible. NFTs are like physical collectibles, like art, but they only exist in the digital world. The global market for NFTs was valued at more than $40 billion dollars in 2021 and compares favorably with the global fine are market.
NFTs have been around for years, but really burst in the public consciousness in 2021. While pictures of disinterested primates may be the readiest example of NFTs in the public eye, there are numerous potential use cases for NFTs, and we are likely only just starting to scratch the surface of how NFTs can be implemented in social and economic settings. Much like cryptocurrencies, technologists and entrepreneurs across the globe are working to push the limits of the technology and find innovative new ways to utilize NFTs in everyday life.
What’s a Security?
Under US law, the way to determine whether or not something is a security is the Howey Test, a judicially wrought solution from the 1946 Supreme Court case SEC v W.J. Howey Co. Without getting into the nitty gritty of the case, the Supreme Court was asked to determine whether the Howey Company had been selling an “investment contract,” and thus a security, to its customers. To determine whether the instrument in question was an investment contract, the Supreme Court devised a four-part definition of the term.
According to the Supreme Court, an investment contract is:
An investment of money;
In a common enterprise;
With the expectation of profit from the investment;
To be derived from the efforts of a third party.
If an NFT issued by a company, exchange, or individual meets all four prongs of the Howey Test, it is a security and is under the purview of the SEC. Under US securities law, all securities sold in the US must either be registered, a long and expensive process, or qualify from an exemption from registration to be sold. Even exempted securities require many attorney billable hours to ensure that they are being sold correctly under the terms of the applicable exemption.
Are NFTs Securities?
The Cryptocurrency Analogy
Nobody is completely sure if NFTs are securities. As of this writing the issue hasn’t been put before a court and so there is no definitive answer to this question. However, the SEC has given plenty of thought to this issue for another digital asset – cryptocurrencies. What the SEC has to say about cryptocurrencies can shed light on how they might treat NFTs, and it is believed that the two will be regulated analogously.
The SEC essentially breaks down cryptocurrencies into two broad categories: 1) replacement currency tokens, such as Bitcoin and Ether; and 2) utility tokens created by companies and issued through initial coin offerings (“ICOs”). Replacement currency tokens typically fail the Howey test and are not considered securities. Utility tokens, depending on how they are used, are much more likely to meet the requirements
of the Howey test and thus be considered a security.
Replacement currency tokens like Bitcoin and Ether fail the Howey test because they do not generate profits from the efforts of others. There is an established market for Bitcoin, and its price increases and decreases based on the trading activities of people in the market. Unlike a publicly traded stock, there is no CEO of Bitcoin working round the clock with the Bitcoin team to try and increase the price of Bitcoin. This is why Bitcoin is considered more like a commodity, whose price rises and falls according to market pressures, rather than the efforts of others.
ICOs were very popular among startup companies trying to raise money by selling utility tokens, or coins, that entitle the holder to things like free t-shirts, early access to new products, the ability to listen in on Board meetings, and dividends or profits from the company’s operations. When a company conducts an ICO and offers utility tokens that entitle buyers to a portion of the company's profits, the utility tokens in question likely meets the Howey Test. Because the utility token is purchased with the expectation of profits based on work done by the Company and its employees, it is more than likely a security.
The NFT Comparison
Like cryptocurrencies, it is helpful to think of NFTs as falling into two categories: 1) Artistic NFTs with intrinsic value independent of others; and 2) Utility NFTs that give the holder some additional benefit outside NFT ownership, like access to an exclusive club. Artistic NFTs will generally fail the Howey Test and should be compared more closely to actual art and other collectibles. Utility NFTs, like utility tokens, have a much greater likelihood of being considered a security, depending on the utility provided.
Once they have been created, artistic NFTs do not rely on the efforts of others to generate profits. Like the Mona Lisa or any other work of art, the price of an artistic NFT is driven by the number of people interested in purchasing it and the amount they are willing to pay. Because of this, artistic NFTs, whose value derives solely from the market price of the NFT, will fail the Howey Test.
I've heard many stories of entrepreneurs who want to issue utility NFTs that give the holders access to special events, the ability to purchase products earlier than the general public, and a percentage of the company’s profits. These NFTs are much more like utility tokens issued in ICOs than artistic NFTs whose value are tied to the overall market for NFTs. Like utility tokens, these utility NFTs entail an expectation of profit based on the efforts of third parties and should be treated as securities.
Conclusion
As I stated at the beginning, the answer to whether NFTs are securities or not is, it depends. If the NFT is artistic in nature and its value is tied to a market for the NFT like art and other collectibles, it’s probably not a security. On the other hand, if the NFT offers dividends or distributions of the company’s profits and its value is tied to these distributions and the company’s ability to make them, it’s more than likely a security.
When trying to determine whether or not an NFT is a security, ask yourself if the investment, and the value you hope to derive from it, is closer to buying a painting or a share of stock. If it feels like buying a stock, you’re likely buying a security and should ask the seller if they are complying with securities laws. The SEC eventually cracked down on utility tokens and ICOs, and smart money would bet they do the same with NFTs in the future.
