As many know by now, non-fungible tokens (“NFTs”) are unique units of data stored on a blockchain that have become an increasingly popular way to buy and sell artwork (as well as all kinds of other things). Although NFTs have existed since around 2014, the NFT market exploded last year, generating an estimated $25 billion in sales in 2021 alone. That extraordinary growth and the continuing evolution of NFT technology present new challenges for state and federal regulators, who are just beginning to scrutinize NFT transactions through the lens of existing securities regulations.
The SEC has aggressively sought to enforce the federal securities laws against issuers of other digital assets, but it has not yet initiated an enforcement action against the creator of an NFT or the operator of a platform that facilitates the offer and sale of NFTs. Given the skyrocketing consumer interest in NFTs and the increasing complexity and financialization of NFT transactions, it is likely only a matter of time before regulators issue guidance related to NFTs and/or begin pursuing enforcement actions against NFT market participants. Meanwhile, at least one private lawsuit has been filed alleging that NFTs are securities, and more are almost certainly on the horizon.
So, the question looms large: Are NFTs securities? The short answer: It depends. Each asset and transaction must be analyzed on a case-by-case basis; below, we discuss general concepts and principles that NFT creators, buyers, sellers and promoters would be wise to consider when analyzing whether state or federal securities laws might apply to any given NFT transaction.
What Is a Security?
The most important definition of a security appears in the Securities Act of 1933 (the “Securities Act”). That definition is expansive. It includes a lengthy list of specific financial products with well-understood legal meanings (such as stocks and bonds), but it also includes broader, more flexible terms (such as an “investment contract”), which can apply to a wide range of financial arrangements.
Depending on what rights or ownership a particular NFT transfers, it conceivably could qualify as any of various specific financial instruments listed in the Securities Act definition. However, because the SEC typically has analyzed other digital assets under the rubric of “investment contracts,” we focus on that category of securities here.
The phrase “investment contract” is not defined in the Securities Act. Instead, the definition of “investment contract” derives from SEC v. W.J. Howey Co., 328 U.S. 293 (1946), a 1946 case in which the United States Supreme Court held that “an investment contract for purposes of the Securities Act 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.” Id. at 298. That definition is known as the Howey test. Over time, courts have adjusted the precise contours of the Howey test as they apply it to new and different scenarios. For instance, courts no longer apply the phrases “invests . . . money” and “solely from the efforts of the promoter or a third party” literally. Rather, any investment of something of value is typically sufficient to constitute an investment of “money,” and the “efforts” of a promoter or third party may be sufficient to fall within the scope of the definition even if the investor also contributes to the profit-making of the common enterprise in some capacity. In other words, an NFT may constitute an “investment contract”—and therefore qualify as a security—if it satisfies the following four factors:
- There is an investment of something of value;
- That investment is in a common enterprise;
- The investor has a reasonable expectation of profits from that investment; and
- Any profit would be primarily the result of the managerial efforts of third parties (e., not the investor).
So, Are NFTs Securities?
Each NFT transaction must be analyzed independently to determine whether it constitutes an “investment contract” or falls within one of the other categories of financial arrangements that constitute securities.
NFTs are, by definition, unique or “non-fungible.” Therefore, they fundamentally differ from many other blockchain-based digital assets such as cryptocurrencies, which are most often undifferentiated (i.e., fungible). Because of their “non-fungible” nature, NFTs also differ on their face from traditional assets commonly known to be securities, such as stock in a publicly-traded company.
But that does not mean NFTs are immune from securities regulations. Although many NFT transactions probably do not qualify as “investment contracts,” certain NFT transactions may—particularly where they involve a “common enterprise” or continued promotional efforts by an individual or entity other than the investor. For instance, NFTs are sometimes sold in large collections of similar or related NFTs that are promoted collectively. If an issuer mints a collection of 300 similar NFTs (e.g., all works by the same artist) and leads buyers to believe that the promoter will continue marketing that collection with the expectation that the investors will be able to resell them for more money in the future, the sales of those NFTs could constitute “investment contracts.” Likewise, the NFT market’s recent explosive growth has led to innovations in NFT technology and market practices, including the rise of the “fractional NFT” or “f-NFT.” Fractional NFTs allow consumers to buy fractional interests (or “shards”) of NFTs, which present a greater risk of implicating securities laws. Similarly, where an original NFT issuer mints an NFT such that a single promotor receives a share of the proceeds each time that NFT is resold, each sale could constitute an “investment contract.”
It is even theoretically possible for the same NFT to constitute an “investment contract” in the context of one transaction, but not another because of the specific way it is packaged and sold. For instance, an NFT of an artwork that is minted and sold by the artist to a collector might not constitute a security in and of itself, but if the collector breaks the NFT into “shards,” sells some of those shards to various buyers, and in doing so promises to promote the artist to drive up the price of the NFT, the second transaction could constitute an investment contract even if the original NFT sale did not.
In short, whether any particular NFT (or NFT shard) is a security—either because it qualifies as an “investment contract” or fits within one of the other categories of financial products listed in the Securities Act definition—will depend on the particular attributes of each individual NFT and the circumstances surrounding its transfer. Given the meteoric rise of NFTs, and the expanding number of applications for NFT technology, it seems likely that regulators will take action and/or issue guidance in this area sooner rather than later. In the meantime, to best avoid violating or becoming subject to state and federal securities laws, NFT issuers should steer clear of marketing their NFTs as investments that will generate profits because of the issuer’s (or another third party’s) promotional efforts.
. See, e.g., Complaint, S.E.C. v. Ripple Labs, Inc. et al., No. 20-cv-10832, ECF No. 4 (S.D.N.Y. Dec. 22, 2020). The SEC defines a digital asset as “an asset that is issued and transferred using distributed ledger or blockchain technology.” Statement on Digital Asset Securities Issuance and Trading, Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets, SEC (Nov. 16, 2018), available at: https://www.sec.gov/news/public-statement/digital-asset-securites-issuuance-and-trading.
. In 2019, the SEC issued a “framework” for analyzing whether any given digital asset is a security, but it predates the rise of NFTs and does not specifically address their unique features or applications. See SEC.gov | Framework for “Investment Contract” Analysis of Digital Assets.
. Amended Complaint for Violations of the Securities Act of 1933, Friel v. Dapper Labs, Inc., et al., No. 1:21-cv-05837-VM, ECF No. 27 (S.D.N.Y. Dec. 27, 2021). The case is pending before Judge Marrero in the Southern District of New York.
. 15 U.S. Code § 77b(a)(1). Although the Securities Exchange Act of 1934 contains its own slightly different definition of “security,” the U.S. Supreme Court has held that the two definitions refer to the same concept and should be interpreted to mean the same thing. Techerepnin v. Knight, 389 U.S. 332, 336 (1967). Likewise, state securities laws tend to mimic the Securities Act for the purpose of defining “security” and state courts often defer to interpretations of the Securities Act when applying their own state securities laws. See, e.g., Jarozewski v. Gamble, 2013 WL 5496535, at *3 (Conn. Super. Ct. Sept. 12, 2013) (looking to interpretation of federal securities laws when analyzing the phrase “investment contract” in Section 36b-3(19) of the Connecticut Uniform Securities Act).
. The full definition is as follows: “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. Code § 77b(a)(1).
. For instance, an NFT conceivably could transfer ownership of “a fractional undivided interest in oil, gas, or other mineral rights.” See 15 U.S. Code § 77b(a)(1).
. See, e.g., Uselton v. Com. Lovelace Motor Freight, Inc., 940 F.2d 564, 574–75 (10th Cir. 1991) (“[I]n spite of Howey’s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract. Instead, the ‘investment’ may take the form of ‘goods and services,’ or some other ‘exchange of value.’”).
. See, e.g., S.E.C. v. Glenn W. Turner Enterprises, 474 F.2d 476, 482 (9th Cir. 1973) (appropriate inquiry is “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”); S.E.C. v. Aqua-Sonic Prod. Corp., 687 F.2d 577, 582 (2d Cir. 1982) (“[G]iven the Court’s repeated directions to consider investment schemes in light of their economic realities and the ease of circumvention if the “solely” language in Howey were to be taken literally, as well as the history summarized in Koscot, supra, we think that if faced with the question the Court would not insist on applying that language literally but would consider whether, under all the circumstances, the scheme was being promoted primarily as an investment or as a means whereby participants could pool their own activities, their money and the promoter’s contribution in a meaningful way.”).
. See, e.g., Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization (Feb. 6, 2020), available at https://www.sec.gov/news/speech/peirce-remarks-blockress-2020-02-06; see also Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985) (a brokerage firm created investment contracts because of the manner in which it identified, sold and managed CDs, even though the objects of the scheme, CDs, had been clearly excepted from the definition of “security” under prior case law).