The U.S. Securities and Exchange Commission (SEC) is ramping up its investigation and potential enforcement activities against sellers of nonfungible tokens (NFTs) and marketplaces that connect buyers and sellers. Regulators have been sniffing around this area for months, and finally have sent out their first subpoenas related to a very limited set of NFTs, focusing on whether the NFTs should be considered securities under federal securities law.
The SEC’s inquiry will likely be focused on whether certain NFT projects are being used to raise money, in the manner of traditional securities, rather than sold as more traditional memorabilia or art.
NFTs are a blockchain technology allowing ownership of such things as digital art or sports memorabilia, although there are many other uses as well. In fact, new uses for NFTs seem to be cropping up every day. It’s these more creative uses that seem to be of significant interest to the SEC. For example, “fractional” NFTs are very much on the SEC’s radar. As the name implies, this packaging allows an issuer to sell pieces of an NFT – this makes ownership more affordable, but also has landed these packages under the SEC microscope. Other NFT and digital asset projects are also being reviewed, such as initial coin offerings (ICO), which are often used to raise money to finance a particular project.
While the latest NFT probe has raised concerns within the industry, blockchain technologies have been under scrutiny by the SEC for some time and the possibility of regulation has been looming.
On June 14, 2018, William Hinman, the former director of the SEC’s Division of Corporate Finance provided some specifics in his remarks at the Yahoo Finance summit in San Francisco. Here is an excerpt:
I am seeing, strictly speaking, the token – or coin or whatever the digital information packet is called – all by itself is not a security, just as the orange groves in Howey were not. Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers… The same reasoning applies to digital assets… The digital asset itself is simply code. But the way it is sold – as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security – because it evidences an investment contract.
The Howey test for securities: What do oranges have to do with it?
You may have noticed that Hinman referenced orange groves in his 2018 remarks. That’s because oranges were the subject of a U.S. Supreme Court case (SEC v. W.J. Howey Co., 328 U.S. 293 (1946)) which set the precedent for whether an asset falls under the purview of the Securities Act. Today, “the Howey test,” which has been refined over the years, has four parts courts and the SEC use to determine whether a product is a security: whether the offering involves (1) an investment of money, (2) a common enterprise, (3) a reasonable expectation of profit, and (4) whether it originates from an entrepreneurial effort.
In Howey’s case, instead of simply selling oranges, he sold leaseback agreements for his orange farm, which turned his farming effort into a security in the eyes of the court. The orange groves themselves were not securities, but the leaseback agreements were.
Today’s regulators who are looking at NFTs and other digital assets appear to be using that same standard to draw many of their conclusions. That likely means that some NFTs will be viewed as oranges—not a security—while other NFT transactions will be viewed similarly to an orange-grove leaseback—a security. The difference is in the packaging, which is why fractional NFTs are under scrutiny; and they are looking a lot like orange-grove leasebacks.
It’s too early to predict how these issues will be resolved, but the SEC issuing subpoenas is a significant step in the evolution and crystallizes the risk everyone involved in selling NFTs faces. Participants in digital asset projects should proceed with caution and with an eye toward increasing SEC involvement. Enforcement appears to be coming, and because virtually no one sought or received adequate advice during the first wave of offerings, there will likely be some fallout that requires management.
In addition to federal securities laws, digital asset transactions will likely continue to receive increasing scrutiny from state regulators and private plaintiffs. Specifically, as we have highlighted previously, Oregon State securities law is interpreted very broadly in myriad ways (including its interpretation of the definition of securities) and it is harsher than other securities laws on parties that arguably participate in the offering or sale of such securities. Therefore, anyone in Oregon developing or selling NFTs or other digital assets should proceed carefully and discuss their situation with Oregon counsel. Moreover, purchasers of NFTs and other digital assets located in Oregon who feel aggrieved by an NFT offeror, or know their offeror is located here, should consider specialized Oregon counsel to analyze any potential claims.
This update is prepared for the general information of our clients and friends. It should not be regarded as legal advice. If you have questions about the issues raised here, please contact Paul Conable, Danny Newman, or the attorney with whom you normally consult.