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Are NFTs at Risk of Being Considered Securities?

In a previous article, I noted that I thought one of the biggest risks when investing in NFTs was the risk of getting hacked and losing everything. If I were to provide another significant risk, it would be regulation and the risk that some of today’s NFTs might be considered unregistered securities by the SEC. If the SEC launches an investigation and determines that various NFT projects have engaged in the unregistered sale of securities, the consequences for those projects would be harsh and there would be ripple effects across the industry as we know it.

Given how quickly the NFT landscape exploded onto the map in 2021, I doubt many founders ever really considered whether their project’s NFTs might be considered unregistered securities and the implications if they are. In this piece, I hope to provide some additional color on the issue so that both founders and investors are more aware of the risk moving forward.

What Does the SEC Consider a Security?

The SEC formally defines a “security” in Section 2(a)(1) of the Securities Act of 1933. The definition is very broad and includes a variety of things, including stocks, bonds, and other forms of profit-sharing agreements. It also includes “investment contracts,” which for our purposes is how NFTs and other digital assets are potentially picked up.

Image Credit: Diego M. Radzinschi/ALM

What qualifies as an investment contract? To make this determination the courts use what is called the Howey test, which was articulated by the U.S. Supreme Court in SEC v. W. J. Howey Co. Under the Howey test, an investment contract exists if there is a contract, transaction, or scheme involving (i) an investment of money, (ii) in a common enterprise, (iii) with the expectation that profits will be derived from the efforts of the promoter or a third party.

This test is broad enough to bring many non-traditional offerings (like NFTs and digital assets) within the definition of a security. There is also guidance out there providing insight into which aspects of the Howey test are potentially most important when looking at digital assets.

“Usually, the main issue in analyzing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others. A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market.” — Excerpt from FinHub’s guidance

The determination as to whether an NFT is a security is ultimately very fact-specific and requires an analysis of the features and characteristics of each project. For example, some NFTs, like many sold by Beeple, are no different from physical paintings sold by independent artists on the street. Selling purely artwork, whether in digital or physical form, is not a security to the extent the relationship between buyer and seller ends after the sale. However, things get very messy when we start looking at NFT projects filled with roadmaps and promises. As the NFT industry has developed, expectations from those who invest in new projects have also grown. This evolution is exciting but also imparts risk.

A Note on Exemptions From Registration

If an NFT constitutes an investment contract and is, in turn, a security, is that the end of the story? Do damages ensue if a project fails to register that security with the SEC (see more on penalties below)? Not necessarily. Everyone who sells securities in the U.S. is required to either register their offering with the SEC or find an exemption from registration. Section 4(a)(2) of the Securities Act exempts from registration sales of securities that do not involve a public offering (i.e., private placement exemptions). This is the statute. The regulation implementing the statute is called Regulation D, which provides various safe harbors for issuers to rely on. Issuers who comply with any of these safe harbors are deemed not to have made a public offering and are therefore exempt from registering with the SEC.

Which safe harbors, if any, would most likely avail NFT projects? For our sake, let’s assume we are looking at the standard NFT project — 10,000 NFTs each at a price in the 0.03–0.1 ETH range. A project like this is comprised of thousands of different investors, not all of which will be considered “accredited investors” by the SEC (which requires that owners meet certain net worth requirements or have professional financial knowledge or experience). Since the Rule 504 safe harbor is open to an unlimited number of non-accredited investors, it is a candidate here. However, Rule 504 only permits $10 million to be sold in any 12-month period, and securities offered pursuant to this Rule are “restricted,” meaning that investors cannot resell for a period of time after purchase and may also be limited in who they can resell to. Given how actively traded NFTs are, it would be very difficult for projects and investors to abide by the rules of this safe harbor.

Similar issues arise when trying to fit a classic NFT launch within the SEC’s crowdfunding or Regulation A exemptions. These exemptions also either have resale restrictions or require compliance with SEC or state securities law filings (e.g., audited financials), none of which projects are typically aware of or will want to satisfy on an ongoing basis. As a result, given how today’s NFT projects are typically structured and launched, there are no clean or obvious ways to fit within the SEC’s available exemptions from registration.

A Case Study — Moonbirds

There are numerous projects out there that are getting very close to crossing the line into being considered unregistered securities. For illustrative purposes, let’s take a look at Moonbirds which is one of the largest projects to date.

Image Credit: Moonbirds

The PROOF Collective

On its face, Moonbirds is a wildly successful profile picture (PFP) NFT collection. It minted on April 16, 2022 for 2.5 ETH and soon reached crazy heights. Within only a week, the project’s floor peaked at about 40 ETH and hundreds of millions ($) in sales volume occurred on the secondary market. Although the hype has settled a bit since then, there is still strong demand — as of writing, the floor price sits at around 27 ETH.

But there is more to this story. The intention is for Moonbirds to be much more than just an art project. In this video, Kevin Rose (the project’s founder) explains his vision.

Moonbirds was founded by the PROOF Collective, which is a private, members-only club. To join, one must hold the PROOF Collective NFT — there are only 1,000 of these and the current floor price is a staggering 84 ETH. What does PROOF membership give you? Think along the lines of the BAYC playbook — you become part of an exclusive community, which leads to special perks and early access to new and potentially profitable crypto projects down the line. For example, each PROOF member received two spots in the Moonbirds mint (which was very oversubscribed).

Image Credit: PROOF Collective NFT

The $58 million that was raised from the Moonbirds mint was recognized as revenue into the “PROOF Company” and will be used as working capital to make Moonbirds one of the top PFP collections in the world. Kevin Rose gets directly to the point in his video — the mint was a capital raise and the money will be used to create a product and deliver value back to the Moonbirds community. For example, the team has already launched a staking mechanism for Moonbirds called “nesting.” The longer owners “nest” (or lock up) their Moonbirds, the more benefits they are expected to accrue. This is just one way the project plans to unlock rewards for holders over time (in-person events, airdrops, physical goods, etc.). Moonbirds is also expected to play a pivotal role in the PROOF’s upcoming metaverse called Highrise which is still in development.

Image Credit: Moonbirds

So, although Moonbirds has essentially been labeled the official PFP for PROOF, the collection is much more than art. Owning a Moonbird gives exposure to the exclusive PROOF ecosystem which many covet and cannot otherwise afford. Kevin Rose describes it as the beginning of a multi-decade journey to build a new media company.

Is Moonbirds a Security as Defined Under Howey?

When viewed strictly under Howey, it does appear that Moonbirds falls within the definition of a security.

Is there an investment of money? Yes. Nearly $60 million was raised from the Moonbirds mint.

Is there a common enterprise? Probably. Thousands of investors participated in the mint and the project’s success depends on the actions of its founders.

Is there an expectation that profits will be derived from the efforts of others? As you may recall, this is the primary factor in analyzing whether a digital asset should be considered a security under Howey. According to FinHub’s guidance, this prong is met when a promoter or other third party provides essential managerial efforts that affect the success of an enterprise, and investors reasonably expect to derive profit from those efforts. After hearing Kevin Rose’s vision for the project and seeing how it is structured (with “nesting,” etc.), it is hard to argue no here. He explicitly states that the money raised from the mint will be used to create a product and deliver value back to the Moonbirds community. The future direction of the project is clearly in the founders’ hands, and investors have been promised value in return. Such a relationship is dangerously close to satisfying this last prong of the test.

So, what does this all mean? The above is a rather cursory analysis of Moonbirds and is not intended to be exhaustive in evaluating whether the project’s NFTs are unregistered securities under current law. However, it does raise various red flags when evaluating risk from a regulatory perspective.

For future founders looking to mitigate regulatory risk, the above factors are something to keep in mind. For example, if a project has a free mint, then there is not an investment of money. If the same project also provides no roadmap or promises for the future, it becomes less clear whether there is an expectation that profits will be derived from the efforts of others. We are already seeing various projects like goblintown.wtf follow a similar model — free mint, no roadmap, no Discord, no utility.

Image Credit: Goblintown.wtf

What if NFTs Are Considered Securities?

If a project’s NFTs are considered unregistered securities and do not otherwise fit within an available exemption from registration, there would be various consequences, none of which are good.

At the outset, the SEC could pursue an enforcement action and every investor who purchased an NFT could potentially sue under Section 5 and Section 12(a)(1) of the Securities Act for the unregistered sale of securities. The founders who initially sold the NFTs would be liable and on the hook for making investors whole in the event any money was lost. These would be civil penalties and not criminal unless the government could also make out a Rule 10b-5 claim for any false / fraudulent statements by the founders.

There would also be broader implications. For example, NFT marketplaces like OpenSea would run the risk of being considered an “exchange” under federal law if they permitted any trading of NFTs considered securities. If this were to occur, OpenSea would be forced to register with the SEC as a national securities exchange. The SEC released a statement in 2018 which highlighted this trading platform risk in the context of ICOs. As a result, if Moonbirds or any other projects listed on OpenSea were declared a security, it is extremely likely that they would be delisted immediately.

For real-world examples of the types of penalties that can be imposed on companies for offering unregistered securities, see the recent SEC press releases for Block.one (2019) and BlockFi (2022).

The Future Regulatory Framework Is Uncertain

Although this article focuses on Howey, how the SEC ultimately decides to analyze Moonbirds or other NFT projects in the future may very well be completely different. For example, consider the recent opinions of SEC Commissioner Hester Peirce, who is dubbed ‘Crypto Mom’ thanks to her support of progressive crypto legislation. Commissioner Peirce believes Howey leaves a lot to be desired in the context of digital assets and that the test, as well as FinHub’s guidance regarding it, may only confuse matters. In an effort to provide more clarity, Commissioner Peirce proposed a legal safe harbor last year that would let a cryptocurrency project take three years to create a “decentralized” blockchain network before having to assess whether it is in compliance with securities laws or whether a token meets the federal definition of a “security.” This safe harbor would provide some breathing room for projects that are navigating an uncertain legal space and hopefully encourage innovation in the process. Although not directly applicable to most of today’s NFT projects, this proposal does show that the regulatory framework governing digital assets is rapidly evolving. However, whether any future changes are more or less accommodating than what we have today is yet to be seen.

“I think it’s really making it impossible for a project to get started without falling into that Howey definition” — Commissioner Hester Peirce, speaking in an interview as it concerns digital assets

Until the SEC provides specific guidance with respect to today’s projects, we are unfortunately left to speculate on which NFTs may be considered a security under current federal law. Some types, such as the selling of fractionalized NFTs (i.e., partial / fungible interests in a single NFT), are already on the SEC’s radar. At the minimum, we know that there is a degree of risk until everything plays out.

This article is provided for informational purposes only and should not be construed as legal advice on any subject matter. You should contact your attorney to obtain advice with respect to any particular issue or problem.

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