For years the SEC has allowed market creators and investors to operate in an unregulated environment; a market beyond the reach of regulators; a market so special that it was beyond the scope of existing law and technology. The result has been digital laissez-faire market, a market of the people that did not need government regulation. The result has been speculation to an unprecedented degree. Or has it?
For perspective, it is important to remember that the American economy has grown through cycles of boom and bust. The United States survived no fewer than twenty-nine recessions before the Panic of 1907 gave us the Federal Reserve System. And it was not until the Wall Street Crash of 1929 that the U.S. Securities and Exchange Commission (SEC) was formed. Congress gave the SEC the power to regulate the securities market to promote efficiency, competition, and capital formation. The definition of a security is quite broad:
The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. 15 U.S.C. § 77b
To this day, the 1946 definition of securities endorsed by the United States Supreme Court in SEC v. W. J. Howey Co., 328 U.S. 293 (1946) remains the outer limit of SEC jurisdiction. In it, the court expansively interpreted the above definition to encompass schemes that escaped precise definition:
An investment contract for purposes of the Securities Act of 1933 means a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.
The court further defined a test—now called the Howey test—that has become foundational to securities regulation as it is a functional test that disregards all formalities:
The requirements of the Securities Act of 1933 must be met even though the enterprise interests in which are offered to the public as investments is not speculative or promotional in character and the tangible interest which is sold has intrinsic value independent of the success of the enterprise as a whole, so long as the scheme involves an investment of money in the common enterprise with profits to come solely from the efforts of others.
For years, securities attorneys have debated the applicability of the Howey test to digital markets and assets. Are cryptocurrencies, their initial offerings (Initial Coin Offerings, or ICOs), and other blockchain assets like non-fungible tokens unique and therefore free of SEC regulation? Or are they just another iteration of the well-worn capital markets concept? The SEC has been slow to act, but predictably, it has increasingly chosen established principles to react to, and prosecute, the new ways issuers are operating and in some cases taking advantage of investors and informational imperfections in the crypto space.
The Rise of NFTs and Digital Assets
Non-Fungible Tokens, or NFTs, are a type of digital asset that represents some aspect of ownership of a specific item, whether digital or real-world. Unlike cryptocurrencies such as Bitcoin or Ethereum, NFTs are unique and indivisible. They have gained immense popularity for their ability to tokenize digital art, music, videos, and other forms of content, enabling creators to sell their work directly to collectors and fans. For example, Beeple’s “Everyday: the First 5000 Days”, which became the world’s most expensive NFT sold for 69 million U.S. dollars. NFT sales volume reached over 10 billion U.S. dollars as of November 12, 2021.1 French firm Sorare, which sells football trading cards in the form of NFTs, has raised $680m (£498m).2
It is important to note that NFTs can vary widely in their actual design. Some convey to the owner of the token copyright or other intellectual property rights, but some serve as little more than a verifiable proof of “ownership” of an original digital work.
SEC’s Stance on NFTs and Investment Contracts
The U.S. Securities and Exchange Commission has been closely monitoring the NFT space to determine whether certain offerings of NFTs could be considered securities. On August 28, 2023, the SEC applied the Howey Test and issued a statement on Impact Theory, LLC. It sheds light on their approach to NFTs.
Impact Theory, a media and entertainment company based in Los Angeles, faced charges for conducting an unregistered offering of NFTs. The SEC’s concern was that these NFTs represented investment contracts, as investors were led to expect profits from Impact Theory’s entrepreneurial and managerial efforts.
Similar to how the famous orange groves that W. J. Howey Co. and Howey-in-the-Hills Service, Inc. “sold” and managed for the investors in the 1940s, Impact Theory, LLC sold NFTs that operated like an ownership interest in their company. This violated Section 5(a) of the Securities Act, which states that:
“[u]nless a registration statement is in effect as to a security, it shall be unlawful for any person, directly or indirectly—(1) to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell such security through the use or medium of any prospectus or otherwise; or (2) to carry or cause to be carried through the mails or in interstate commerce, by any means or instruments of transportation, any such security for the purpose of sale or for delivery after sale.”
NFTs—unless they are non-transferrable—are traded in the secondary market. When they have the functional equivalency of an ownership interest, like the SEC determined Impact Theory, LLC’s token to be, there is a risk that the issuer will be considered to have created a secondary market in unregistered securities.
After Impact Theory, LLC’s token offering commenced on October 13, 2021, the KeyNFTs tokens also were traded on various secondary market crypto asset trading platforms. Impact Theory stated on its websites and social media channels that KeyNFTs could be purchased and sold on two such secondary market platforms. Impact Theory programmed the smart contract for the KeyNFTs so that the company received a 10% “royalty” on each secondary market sale. The use of a secondary market to sell unregistered securities violated Section 5(c) of the Securities Act, which states in relevant part that
“[i]t shall be unlawful for any person, directly or indirectly, to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to offer to sell or offer to buy through the use or medium of any prospectus or otherwise any security, unless a registration statement has been filed as to such security.”
An Evolving Frontier
The digital marketplace is an evolving frontier. But long tested regulatory principles still apply:
- It is the Issuer’s burden to show that they qualify for an exemption from registration;
- Securities laws disregard formality for form; and
- Just because the regulators have not acted, does not mean that they won’t.
The Impact Theory case serves as a reminder that innovation often outpaces regulation. The ongoing dialogue and evolving understanding of digital assets and securities regulations will play a crucial role in shaping the future of digital creativity and ownership. As technology advances and markets mature, the SEC will continue to attempt to balance its mandate to “regulate the securities market to promote efficiency, competition, and capital formation.”
At Davillier Law Group we have helped entrepreneurs manage the complexities associated with operating in the forefront of the digital securities frontier. We never forget that business fundamentals and conservative strategies are time-tested bedrocks of long-term success. Whether we are advising a company launching an ICO, integrating AI into their processes, considering digitization of shares, using virtual currencies, or otherwise exploring digital efficiencies, DLG understands the technology, works with management and educates decision makers to forego the hype, evaluates business fundamentals, and helps our clients make informed decisions within the regulatory environment, both of the present and what may come in the future.