The Slippery Status of NFTs
POMERANTZ MONITOR | MARCH APRIL 2023
Non-fungible tokens (“NFTs”) have become scorching hot commodities, which has led the largest and most powerful brands across various industries to mint their own. Like cryptocurrencies, the surge in popularity of NFTs has raised difficult questions concerning whether they function as securities, which would subject them to regulation by the U.S. Securities and Exchange Commission (“SEC”) and compliance with securities laws.
NFTs are digital assets whose authenticity and ownership are recorded, or minted, on a blockchain. These assets may range from digital artwork created by a known artist, such as Alec Monopoly, to an NBA video highlight of Jalen Brunson draining a game-winning shot for the Knicks. The unique identification code and metadata assigned to each NFT is baked into its token and makes it non-fungible. NFTs can be traded and exchanged for money, cryptocurrencies, or other NFTs. NFTs, like cryptocurrency, are stored in digital wallets. Although the image linked to one NFT may be identical to the image linked to another NFT, the tokens themselves are not interchangeable. This distinguishes NFTs from cryptocurrencies. Cryptocurrencies are interchangeable, or fungible, tokens. A digital crypto coin on one blockchain is equal in value to any other digital crypto coin on the same blockchain, in the same way one dollar equals, and is exchangeable with, any other dollar. On the other hand, there may be countless NFTs of the same image – a baseball card, for example – but each NFT has its own unique identifier, akin to a numbered series of the same baseball card, and although it can be traded, it is not interchangeable with any other NFT.
Significantly, when an NFT is purchased, the purchaser only acquires the NFT. Generally, ownership rights over the image attached to the NFT remain with the creator of the work. NFTs derive their perceived value based on their scarcity. Thus, NFT developers often issue their NFTs in limited drops, making them more difficult to obtain. The rarer in NFT is, the higher its value. Additionally, the work attached to the NFT also impacts its value.
A blockchain, on which an NFT’s authenticity and ownership are recorded, provides a unique decentralized method of digitally storing information. The information is collected and stored in blocks which are linked together via cryptography. The key perceived benefit of a blockchain is that it is more secure and trustworthy than centralized authorities because it stores its information in multiple locations and intentionally makes it more difficult to add, change or remove information.
The definition of a security in the Securities Act is broad and includes the term “investment contract” within it. However, the Securities Act itself does not clarify what constitutes an “investment contract.” The Supreme Court addressed this issue and provided a framework for determining what is an investment contract, and, therefore, a security that must be registered with the SEC, in S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946).
Based on the definition set forth in Howey, courts have applied a three-pronged test to determine what constitutes an investment contract. To satisfy the Howey test, the moving party must demonstrate: (1) an investment of money; (2) in a common enterprise; (3) with the expectation of profits derived from the efforts of the promoter.
The manner in which NFTs are acquired should satisfy the first prong of the Howey test without opposition. To obtain an NFT, an individual or entity must purchase it in exchange for money.
The second prong of the Howey test, establishing a common enterprise, is a little trickier. A common enterprise can be demonstrated through a showing of either horizontal or vertical commonality. Plaintiffs will likely focus on horizontal commonality to satisfy this prong as it is more favorable, given how NFTs function. Horizontal commonality requires: (1) the sharing or pooling of the funds of investors; and (2) that the fortunes of each investor in a pool of investors are tied to one another and to the success of the overall venture.
To demonstrate the sharing or pooling of funds, the movant must first demonstrate that the funds received by the promoter through an offering are reinvested by the promoter into the business or, more broadly, are tied to an improvement of the ecosystem as a whole. Whether a particular NFT offering meets this requirement may vary on a case-by-case basis, based on the amount of entanglement and dependence there is between the developer of the NFT and the operator of the blockchain on which it is recorded. In a recent decision in the Southern District of New York (“S.D.N.Y.”), Judge Marrero found that this requirement was met where the defendant was the owner and operator of the NFT platform and also the creator, developer and operator of the blockchain on which it ran. Because the success of the NFT was entirely dependent upon the success of the blockchain, it could be plausibly alleged that the company operating both would use funds generated to grow the totality of its network. For similar reasons, the court found that the second requirement – that the investors and enterprises’ fortunes be tied – was also met.
However, the S.D.N.Y. decision was narrow and explicitly limited to the particular facts of that case. Many NFT platforms are structured differently, with separation between the owner and operator of the NFT platform and the blockchain on which it relies. Without the overt substantial entanglement between the two, it will be more challenging to establish horizontal commonality, which will largely turn on just how close the relationship between the two is. Additionally, this prong may turn on whether plaintiffs make specific allegations regarding how the funds at issue are being used in conjunction with both the NFT platform and its infrastructure.
The third prong of the Howey test is also subject to debate, presenting another hurdle to clear for plaintiffs looking to establish that NFTs are securities. It requires the expectation of profits derived from the efforts of a promoter. Courts have consistently held that this is an objective test.
The expectation-of-profits prong likely turns on the public statements disseminated by the developer of a particular NFT in conjunction with the totality of the circumstances surrounding its issuance. Public statements that explicitly tout the ability to generate profit through the purchase of a particular NFT should easily satisfy the first portion of this prong. Further, Judge Marrero, in the S.D.N.Y., recently rejected an argument that statements that do not explicitly reference gains or losses do not give rise to the expectation of profits. Consistent with this decision, statements, such as those touting record sales of a particular NFT, may give rise to the expectation of profits when considering the cost of acquiring NFTs on that platform.
Another argument related to the third prong, which may prove more difficult for plaintiffs to overcome, is whether purchasers of NFTs do so based on their desire to collect and consume them. For example, a die-hard New York Mets fan may purchase Mets-affiliated NFTs, with no intention on turning a profit, because of their strong passion for the team and their personal enjoyment. Drawing this distinction may pose a difficult challenge. However, one court has already determined that drawing this distinction is not necessary at the dismissal stage, despite such challenges.
Whether profits are derived from the efforts of the promoter poses similar questions to those assessed when evaluating horizontal commonality. This will require a case-by-case assessment of how the particular operation is organized and functions to determine how dependent those who purchase a particular NFT are on the efforts of its developer.
Since the Howey test depends on a wide range of factors that are unique to both the NFT platform being assessed and the blockchain on which it operates, determining whether an NFT is a security requires a case-by-case analysis. Given NFTs’ recent rise to prominence, as more class action litigation is brought against NFT developers, it will become clearer what plaintiffs must plead to establish that an NFT is a security subject to the securities laws. Additionally, it will be important to track whether the SEC takes a particular interest in NFTs, as it has identified the regulation of emerging technologies and crypto assets as one of its 2023 priorities. The landscape of NFTs is ever-evolving and more clarity regarding whether they are securities, subject to regulation by the SEC, should be obtained as courts and relevant agencies hone in on them.