In the past 18 months the NFT phenomenon has fully entered the public consciousness. And like any new blockchain phenomenon, the immediate questions range from is this “legal” to how do we raise money with it?
As a securities firm, our focus is often on the use of blockchain for fundraising activities and when, why, and how those activities may be governed by extant legal frameworks such as the Securities Act of 1933. As a reminder, a security has significant regulatory and other compliance requirements that can affect fundraising activities across the abord and create liabilities for the issuer and others. Hence, many legal discussions focus merely on the securities side of the question (i.e., the legalities of using NFT’s to fundraise).
However, like all things blockchain, NFT’s in any given use case can and very often do morph into being “all things to all people” at once. Hence, they are often simultaneously rights management devices, fundraising devices, arts pieces, collectibles, and even potentially commodities. And either frustratingly or refreshingly, all those distinct roles implicate a raft of legal frameworks, dilemmas and considerations. From our perspective this makes NFT’s perhaps one of the most exciting blockchain adoption stories to date but also one of the most challenging. And from our perspective, the fundraising question is a not a simple binary inquiry. Rather context, intention, functionalities and outcomes are important, particularly in regard to the question of when an NFT will be deemed a security.
Hence, rather than provide a high level overview article, we will attempt to address NFT’s in greater detail through a series of articles, beginning with dissecting its prime use cases and then focusing on instances where the foregoing might give rise to securities treatment. And by initially focusing on use cases that likely do not give rise to securities treatment, we can get a better understanding of when and why an NFT might be deemed a security. This is particularly the case with NFT’s probably more than any other digital assets classes. And this is due to the fact that the question of whether or not an NFT is a security is likely answered in the negative, when dealing with a straightforward and utilitarian undertaking (e.g., the owner of a painting uses and NFT to evidence ownership for a variety of reasons, from licensing to using the painting as collateral, etc.). However, increasingly NFT’s are being leveraged as a fundraising vehicle in tandem with those utilitarian use cases, creating a very complicated portrait (with a significant proliferation of these offerings in the first few months of 2022).
ABC’s of NFT’s or what is an NFT anyway?
Basic Functions. The abbreviation NFT refers to “non-fungible tokens” (i.e., unable to be replaced by another identical blockchain digital asset or mutually interchangeable blockchain digital asset). And in fact they are an emerging digital asset class within the overall blockchain sphere. Although NFT technology emerged circa 2014, it was the absolute explosion of NFT’s over the past eighteen months in the collectible art and media space that really drove public awareness (and in fact many of those uses are not likely securities). Indeed, nearly every day the headlines carry news of major NFT purchases, with celebrities, content creators, artists, performers, and athletes all jumping in on the craze by evangelizing and participating in NFT projects across the board (from fine art to golf courses).
NFT’s add unique digital verifiability, ownership, and control to unique assets by leveraging blockchain. Generally speaking, an NFT is a digital asset, which is represented and recorded on a blockchain ledger to document ownership and authenticity of a unique asset. Its “non-fungible” nature is what differentiates it from other digital assets and more septically more commonplace blockchain assets, such as Bitcoin or Ethereum. Like Bitcoin or Ethereum most other blockchain digital assets are, by design, fungible in nature, meaning that they are in fact “interchangeable.” For example, one bitcoin is essentially the same as another in terms of value and operation, much like one dollar bill should be the same as the other (despite the unique serial numbers of the dollar bills). As to what can be represented by an NFT, seemingly there is no limitation at all (tangible, intangible, digital, real world, mobile, immobile, etc.), as anything can be represented by an NFT providing it is itself unique. So for example, everything from paintings, to cars, real property, and their digital counterparts such as images, documents, videos, and tweets can be represented by an NFT. Indeed, perhaps one of the most newsworthy NFT’s came in the form of a digital piece of art (i.e., the art itself was already a non-physical, digital piece), Beeple’s $69 million “The First 5,000 Days” NFT (which as of MID 2021 was most expensive NFT sold to date, only be eclipsed by the “The Merge” NFT which was sold to approximately 30,000 collectors for $91.8 million). And recognizing the limitless nature of NFT’s there are some notable commercial partnerships already underway to expand NFT’s reach, such has IBM’s NFT pilot to enhance monetization and liquidity of commercial and industrial IP.
Minting. In order for an NFT to come into existence of must first be “minted.” Essentially, minting is the process of converting digital files (or digital representations of physical assets) into digital assets stored on the blockchain (which may then be further “tokenized” on that blockchain). And in theory because of the use of decentralized blockchain ledgers, post minting transaction verifiability is assured (licensing, transfer, etc.). NFT’s are often (but not always) minted on the Ethereum blockchain through the ERC‑721 token standard using the Solidity smart contract language. However, NFT’s can also be minted on the EOS, Cardano, Flow, and Tron blockchains, among others.
Smart Contracts. NFT’s cannot function without the ubiquitous “smart contract.” A smart contract is an Internet deployed computer protocol, language, and code that programmatically validates, facilitates, and executes the performance of “contract” terms. Smart contracts play a crucial role in the transfer, minting, verification, and other transactional components of the nearly every NFT use case.
Core Use Cases of NFT’S (i.e., Non-Securities Use Cases Per Se)
Perhaps the best way to determine when NFT’S are securities is to better understand when they are NOT likely securities in and of themselves. The below describes some key use cases and rationales for NFT deployment.
Monetization/Rights Management. For years one of the key “selling points” for blockchain was its application in the often tricky, confusing, and opaque world of rights management for unique and often intellectual property driven items (e.g., art, collectibles, content, etc.). Accordingly, some will argue that the original use case for NFT’s is the verifiable tracking and monetization of such unique, particularly intellectual property driven assets. And traditionally in the world of art for example, recording a transaction of any kind in a public and verifiable fashion often proves difficult, if not impossible. NFT’s appear to be delivering on that promise, at least in theory.
Precisely because of the use of blockchain, the sale and transfer of any NFT creates a verification event on the applicable blockchain, providing all parties to the transaction (and the public at large in many instances) “digital proof” of the sale and transfer. The blockchain verifies the transaction, which acts as a digital certificate of validation regarding the ownership of the NFT, and in some cases the original creator. Migrating art transactions to NFT’s theoretically creates the type of transparency and long-term price “know-how” that can create new avenues for liquidity.
Certification/Verification. The other key “pain points” in the content world is certification and verification of authentic originals that arose with the original artist and/or content creator. And while there are several very clever methods for verifying original artwork, these methods present multiple problems (e.g., the torn paper method, where one piece of torn paper from the original artwork acts as a “private key” when matched up to the piece of paper was torn from which acts as a “public key”, which is as used by certain super artist like Banksy). Clever methodologies like this still have multiple verification points, are cumbersome and time intensive, and are susceptible to theft/lost/fraud at multiple points including with the generation, storage, and delivery of certificates of authenticity.
With NFT’s, many of those pain points are eliminated, since the NFT efficiently wraps all of those functions into one solution. Buying through NFT related smart contracts results in most of the key data points be established through lines of code within a singular smart contract. For example, that smart contract can definitively establish the substance and nature of the work, contractual rules that govern how and when the work can be transferred, licensed, or otherwise exploited, any royalty schemes, etc. Moreover, NFT’s also have integrated identifiers and markers that are difficult to counterfeit such as wallet addresses which identify key parties in an immutable and verifiable fashion, barring hacking and the like.
Given the integration of both identification and authenticity certification, theoretically NFT’s eliminate the need for third-party intermediaries such as the one specifically authorized by Banksy. Moreover, they provide transparency and verifiability across multiple parties in real time.
Royalties. In addition to the above use cases, through the use of royalties NFT’s also allow for the long-term verifiable monetization of its underlying assets, be they art, content, and or collectibles. A royalty is the right of the owner controlling party of a given intellectual property to receive payment against use or transfer of that intellectual property on an ongoing transaction by transaction basis. Particularly in the case of visual arts, artists only typically receive a onetime payment upon the sale of the actual physical (or digital) artwork. However, by representing that artwork using an NFT, the potential for multiple sales transactions with their own rights and royalty streams is unlocked. And indeed, smart contracts can and do build royalty streams making clear that the original party at the end of the rights chain receives compensation against future transfer licensing events.
For example, Zora is a relatively new NFT platform that allows for NFT’s minted on the platform to carry a so called “creator share,” which is a percentage of all future sale proceeds to be received by the NFT creator. Nonetheless, Zora has notable limitations since it requires its own smart contracts to effectuate the royalty scheme, meaning that the sale transaction has to occur on the platform. However, there are currently efforts to enhance blockchains including Ethereum to natively carry royalty functionalities. Zach Burks and James Morgan authored an “Ethereum Improvement Proposal” or EIP-2981 towards the establishment an ERC-721 Royalty Standard to create NFT’s that could track and remit royalties in fashion agnostic to which platform they are sold on or through.
US Securities Expansive “Investment Contract” (and the Howey Test)
The above use cases, especially when not paired with a fundraising enterprise, represent the digitization of commodities for liquidity, monetization, and verification purposes. And very likely, those particular use cases which hew more closely to the original mission of NFT’s probably are not securities. Stated another way, when NFT’s are being used in these capacities, it is a far easier question as to whether or not securities treatment should apply.
However and unfortunately, the definition of a security under US law is very expansive, not merely because of the definition of a “security” as contained in the Securities Act of 1933 and Securities Act of 1934, but also because of the SEC’s general enforcement posture and approach to digital assets. Many observers would agree that the SEC tends to look at digital assets from lens of “why isn’t this a security?,” as opposed to the reverse. And accordingly, when NFT’s are intertwined with fundraising activities (even if those activities are not ostensibly fundraising driven), one should be cognizant of the fact that securities treatment could arise.
Under the 33’ and 34’ acts, are similar and broad enough to encompass certain NFT use cases and deployments. In particular Section 2(a)(1) of the Securities Act of 1933 defines security as:
The term 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.
However, the Securities Act of 1933 does not expressly have any definition or guidance with regard to digital assets. Accordingly, typically where the SEC has attempted to apply securities treatment to the deployment of digital assets, it has used the “investments contract” portion of the definition as a “catchall” to capture digital assets. The now famous (at least in crypto world) test for what constitutes an investment contract was articulated by the U.S. Supreme Court in SEC v. W. J. Howey Co. Under the Howey test, an investment contract 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. And when using the Howey test to divine the presence of an investment contract, a variety of digital assets offerings that may not intuitively appear to be securities offerings, have in fact been deemed securities offerings.
To provide some clarity, in 2019 the SEC provided its “Framework for “Investment Contract” Analysis of Digital Assets”, which helps clarify the thought process of the agency with regard to analyzing whether or not a digital asset is a security. While it should be noted that that framework does not specifically reference NFT’s and the SEC has not provided any specific NFT guidance, the SEC stated:
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.
Against this backdrop, any determination of whether an NFT is a security is fact driven, necessitating a feature by feature analysis of the NFT. However, the analysis does not end there. It would also have to factor in the entire investment opportunity that the NFT forms a part of. Again in the case of NFT’s that SOLELY provide enhanced digital features to art, content, and/or collectibles, they are unlikely to be deemed securities, particularly because these use cases do not really involve shared investor risk and pooled capital fundraising. And indeed in those cases, accretion in value is not fundamentally dependent on the “efforts of others” (e.g., promoters, developers, management teams, and other third parties). Also as stated by the SEC in its digital assets framework, “price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered ‘profit’ under the Howey test.”
Hence, the question of NFT’s being deemed securities is not as simple as whether it can increase in value and nor should it be, given the above discussion. That being said, the next part in this series will focus on more fundraising oriented uses of NFT’s that will more likely be deemed securities, with an emphasis on identifying features of those offerings that differentiate them from the use cases above.
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