When is an NFT a ‘security’ and why should you care?
There has been plenty of interest in the music industry surrounding NFTs and what they might mean for artists. Unfortunately, the recency of the technology means there are a lot of unanswered questions surrounding NFTs, like whether or not they’re a securing, and therefore within the authority of the U.S. Securities and Exchange Commission.
Guest post by Chris Castle of Music Technology Policy
There’s a serious issue of whether an NFT is itself a “security” bringing it within the authority of the U.S. Securities and Exchange Commission.
The SEC enforces U.S. securities regulations designed to protect investors through disclosures by “issuers” and other market-making rules. To my knowledge, the SEC has not ruled on NFTs as an asset class, and likely will review each on a case-by-case until a practice develops regarding categories of these financial products. But there are comparable financial products that may indicate how the SEC will move in the future. Recent SEC guidance on celebrity endorsement of Initial Coin Offerings for crypto currencies (that monetize NFTs) and the SEC’s prosecution of Ripple Labs may shed some light by analogy for issuers of NFTs.
“Anti-Touting” Rules Implicated in Celebrity Endorsement of Crypto
The SEC has issued some guidance about entertainers endorsing cryptocurrency initial coin offerings that may be analogous to some NFTs:
Celebrities and others are using social media networks to encourage the public to purchase stocks and other investments. These endorsements may be unlawful if they do not disclose the nature, source, and amount of any compensation paid, directly or indirectly, by the company in exchange for the endorsement….Celebrities and others have recently promoted investments in Initial Coin Offerings (ICOs). In the SEC’s Report of Investigation concerning The DAO, the Commission warned that virtual tokens or coins sold in ICOs may be securities, and those who offer and sell securities in the United States must comply with the federal securities laws. Any celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion. A failure to disclose this information is a violation of the anti-touting provisions of the federal securities laws. Persons making these endorsements may also be liable for potential violations of the anti-fraud provisions of the federal securities laws, for participating in an unregistered offer and sale of securities, and for acting as unregistered brokers. The SEC will continue to focus on these types of promotions to protect investors and to ensure compliance with the securities laws.
The Big Enchilada: Is any NFT a “Security”?
Determining whether an NFT is a “security” is a key step in evaluating the sale of NFTs and whether a seller of NFTs needs to comply with securities laws, disclosure requirements and limitations on investors. This seems more likely to apply if the NFT uses the “smart contracts” we hear so much about in the cryptocurrency discussion. One way that an NFT might be regulated as a security is if it is determined to be an “investment contract” under the test in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The Howey test asks if:
1. there is an investment of money or some other consideration,
2. in a common enterprise,
3. with a reasonable expectation of profits,
4. to be derived from the efforts of others.
So that’s pretty inclusive criteria. Before anyone brushes aside the possibility that the SEC could determine an NFT to be a security, take a close look at those criteria because how the basic question is answered is one to discuss thoroughly with your securities litigation lawyer (or engage one). That advice may be a good idea whether you are either an issuer or an endorser of an NFT.
One might say that a one-off sale of a unique product—which is truly “nonfungible” in the sense that there is only one of the product in existence—may be less likely to be determined a “security” under the Howey test.
But—if the asset being sold is or is part of a “smart contract” (similar to Howey’s investment contract), or an NFT representing shares of a small interest in a royalty stream start looking like shares of stock, the SEC may rule that the NFT is a security.
Your NFT is a “security”–now what? SEC v. Ripple Labs, Inc.
Let’s say that your NFT is a security under Howey. Then what happens? The rule of thumb is that if you issue securities in the United States it must either be pursuant to the IPO rules (under Form S-1 for those reading along at home) unless the issuer can rely on a securities law exemption (of which there are many). Also realize that there very well may be somewhat or entirely duplicative state securities laws you must also comply with as well as potentially foreign securities laws if your purchaser or transaction is or is deemed to be subject to the jurisdiction of securities regulators outside the United States.
According to the SEC’s complaint, Ripple; Christian Larsen, the company’s co-founder, executive chairman of its board, and former CEO; and Bradley Garlinghouse, the company’s current CEO, raised capital to finance the company’s business. The complaint alleges that Ripple raised funds, beginning in 2013, through the sale of digital assets known as XRP in an unregistered securities offering to investors in the U.S. and worldwide. Ripple also allegedly distributed billions of XRP in exchange for non-cash consideration, such as labor and market-making services. According to the complaint, in addition to structuring and promoting the XRP sales used to finance the company’s business, Larsen and Garlinghouse also effected personal unregistered sales of XRP totaling approximately $600 million. The complaint alleges that the defendants failed to register their offers and sales of XRP or satisfy any exemption from registration, in violation of the registration provisions of the federal securities laws.
“Issuers seeking the benefits of a public offering, including access to retail investors, broad distribution and a secondary trading market, must comply with the federal securities laws that require registration of offerings unless an exemption from registration applies,” said Stephanie Avakian, Director of the SEC’s Enforcement Division. “We allege that Ripple, Larsen, and Garlinghouse failed to register their ongoing offer and sale of billions of XRP to retail investors, which deprived potential purchasers of adequate disclosures about XRP and Ripple’s business and other important long-standing protections that are fundamental to our robust public market system.”
That last sentence is important and tells the defendants what they have to prove—essentially that they were not selling securities so did not have to comply with the registration and disclosure requirements of federal securities law. (But see controversial speech of former SEC director William Hinman on applicability of Howey to digital asset transactions.) Combined with the anti-touting rules applicable to the crypto currency guidance, celebrities in all fields, including songwriters, artists, record companies, sports figures and beyond have to be careful.
While it’s beyond the scope of this post, it must also be asked whether an NFT platform that is determined to be selling unregistered securities has exposure as an unregistered broker dealer or other violations.
Not quite so simple as letting gas escape into the Ether.