Digital Assets Get Real: UK Proposes New Legal Category for Crypto, NFTs

1000 648 Yusuke Hisashi

In response to the evolving landscape of digital assets, the United Kingdom’s Law Commission (UKLC) has proposed a new category of personal property specifically tailored to cryptocurrencies and other digital assets. Businesses and platforms incorporating Web3 technologies should understand how the proposed law could impact their operations and whether a similar legislative approach is needed in the United States.

The UKLC report, spurred by a mandate from the British government, challenges the conventional classification of private property. It posits that existing legal definitions fail to adequately capture the distinct characteristics of digital assets, which encompass cryptocurrencies and NFTs, among others. The traditional bifurcation of property into “things in possession” (tangible assets like real estate) and “things in action” (intangible rights such as debt or shares of stock) does not fully cater to the unique nature of digital assets.

To address this gap, the UKLC recommends the introduction of a third category termed “digital objects.” This would serve as a legal umbrella for a broad spectrum of digital assets, from cryptocurrencies to digitized instruments like carbon emission credits or export quotas. The inclusion of such a diverse array of assets underscores the nuanced approach the UKLC advocates in recognizing the multifaceted world of digital assets.

The UKLC suggests that an expert panel be created to advise courts on complex legal issues arising from digital assets. The objective behind this proposal is to equip the judiciary with the necessary expertise to adjudicate matters involving these novel forms of property effectively.

The recommendations seek to position the UK as a global epicenter for crypto assets. This goal aligns with the vision expressed by British Prime Minister Rishi Sunak in April 2022, highlighting the nation’s commitment to fostering innovation within the realm of digital assets.

Implications for Crypto Companies

If adopted, the legislation is likely to require crypto operators and emerging technology companies dealing with digital assets to obtain specific licenses to operate within the UK. This move would formalize the legal status of cryptocurrencies, categorizing them as a distinct type of financial asset or security. Consequently, it could lead to greater regulatory scrutiny, necessitating businesses in this space to adapt their operational, compliance, and risk management strategies accordingly.

The proposal also carries considerable tax implications. The UKLC’s document mentions an amendment to self-assessment forms concerning crypto assets. This suggests that from fiscal year 2025-26 onward, UK citizens and companies will be required to declare their digital assets for the first time. The UK treasury has not provided specific figures for anticipated revenues from this new tax category. This development could necessitate changes in financial reporting and tax planning strategies for individuals and businesses dealing in digital assets.

Should the US Follow Suit?

In 2022, the United States took steps to address the unique characteristics and challenges posed by digital asset transactions. The Uniform Commercial Code (UCC), a comprehensive set of laws governing commercial transactions in the US, was amended by a joint committee of the Uniform Law Commission (ULC) and the American Law Institute (ALI). These amendments specifically excluded cryptocurrencies from the electronic money category and introduced the concept of “controllable electronic records” (CERs).

CERs are defined as “records stored in an electronic medium.” This broad definition encompasses not only existing blockchain-backed assets but also future types of digital assets. It includes crypto assets, as well as NFTs, thereby recognizing the diverse nature of digital assets in the modern economy. These changes to the UCC came in response to several states, including Wyoming, Kentucky, Idaho, and Tennessee, passing non-uniform statutes to define and regulate interests in digital assets. Despite the differences in state laws, most state legislatures are expected to adopt the UCC’s proposed amendments, albeit on varying timelines.

Given these developments, some argue that there may be no need for the US to introduce a separate category for digital assets. They contend that such a move could potentially stifle, rather than encourage, growth in the digital economy. There is a widely held belief that the existing legal regime has demonstrated sufficient flexibility to accommodate digital assets. Courts have managed over several years to ascribe proprietary rights to “digital assets of value,” creating a level of certainty in many areas related to digital assets. While there are still gray areas or uncertain aspects, these are often highly complex and nuanced, requiring specific expertise for effective resolution. If US legislators decide to introduce a new category for digital assets, they say, it would be advisable to implement only limited statutory reform. This should be designed to bridge the gaps where common law may fall short, without disrupting the broader legal landscape.

To ensure informed decision-making, it may also be prudent to establish a panel of industry experts. This panel could provide non-binding guidance and assist in navigating the complexities of digital asset regulation. Such an expert-led approach could help balance the need for regulatory clarity with the importance of fostering innovation in the digital economy.

Conclusion

The evolving digital asset landscape has prompted countries worldwide to reassess their legal and regulatory frameworks. The UKLC’s proposal to introduce a “digital objects” category represents a significant step in acknowledging the unique characteristics of digital assets and adapting the law to encompass them.

In contrast, the US has yet to establish a comprehensive regulatory and enforcement framework for digital assets. As it stands, participation in the US digital asset markets necessitates careful consideration of the regulatory status of implicated transactions, be they securities, commodities, or otherwise. This challenge is further complicated by the divergence in international regulatory approaches, necessitating careful analysis of multi-jurisdictional transactions involving digital assets.

To strengthen its digital economy, the US needs robust regulations on cryptocurrencies and digital assets. One solution could be to emulate the UK’s approach and introduce a separate category for digital assets through limited legislative reform. Such a move could position the country as a hub for digital assets, particularly as several states are already debating the legal status of these assets.

As legislation around digital assets continues to develop, stakeholders must remain informed and adapt their strategies accordingly. This will ensure compliance and the optimization of operations in this dynamic and complex market.

Gamma Law is a San Francisco-based Web3 firm supporting select clients in complex and cutting-edge business sectors. We provide our clients with the legal counsel and representation they need to succeed in dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Can Hong Kong’s Retail Crypto Laws Lure US Firms?

1000 648 David Hoppe

With Hong Kong’s recent announcement that it will legalize retail trading of cryptocurrency, how should American crypto firms approach business operations in Asia? 

Hong Kong’s new policy will allow retail investors to trade in cryptocurrencies and crypto exchange-traded funds. The move was made with the aim of rebuilding Hong Kong’s status as an international fintech hub. In a study conducted by blockchain specialist Chainalysis, Hong Kong’s overall global ranking for crypto adoption fell to 46 in 2022, down from 39 in 2021. Further, digital-token transaction volume in Hong Kong expanded by less than 10% in the year ending May 2022.

Up to 2018, big exchanges like Binance and FTX, lured by Hong Kong’s laissez-faire reputation, called Hong Kong home. That year, however, Hong Kong introduced a voluntary licensing program that restricted crypto platforms to clients with portfolios of at least HK$8 million (just over US$1 million). This made several crypto platforms wary of Hong Kong as a crypto-friendly jurisdiction. Binance and FTX left for friendlier climates in Singapore while crypto entrants to Hong Kong dried up. Only two firms, BC Group and HashKey, obtained permits in Hong Kong that year. Hong Kong’s reputation as a global fintech hub has gone downhill ever since.  

The fundamental question for American and other Western crypto-related businesses is whether Hong Kong’s sector will be able to rise from the ashes and if so, does it provide an opportunity to gain a foothold in Asia?

Probably not.

It is unlikely that HK has the potential to regain its former glory as a crypto hotspot for American emerging technologies companies.

HK’s Mandatory Licensing Regime Is Still Very Restrictive

Under the new virtual asset service providers (VASP) regime (which takes effect from 1 March 2023), virtual assets (VAs) that fall within Hong Kong’s statutory definition of securities or futures contracts may only be traded on crypto exchanges operated by intermediaries licensed by the Securities and Futures Commission (SFC). Intermediaries that distribute, sell, broker, or advise on VAs must be licensed and comply with SFC’s regulations. Further, for the time being, only licensed VASPs will be permitted to provide their services to professional investors. This restriction has given rise to skepticism among people in Hong Kong who expect that the licensing regime will do little to facilitate trading. The general view is that even if consumers and small-scale investors can deal directly with retail users, their opportunities still will not be as attractive or as competitive as overseas platforms. In summary, the legal requirement to become an accredited or licensed VASP is still quite strict and it is not very clear how many American crypto firms would subject themselves to such rigorous licensing regulations.

More Favorable Jurisdictions

Other jurisdictions outside Hong Kong may be viewed more favorably by Western companies contemplating entry into the Asian market. Singapore, in particular, presents a highly lucrative base for crypto businesses, thanks to its stable economy and friendly business climate. Singapore has no capital gains tax and has steadily adopted policies that observers commend as crypto-friendly. For example, in January 2022, the Monetary Authority of Singapore (MAS) implemented consumer protection laws limiting the onslaught of advertisements touting digital assets on billboards and crypto ATMs. It seems unlikely that the new Hong Kong regime is robust enough to propel it to lead cryptocurrency adoption and investment in Asia.

Even Japan could provide more comfortable accommodations for Asia-bound American crypto companies, as Tokyo makes obtaining the required crypto business license from the Financial Services Agency (Kin’yū-chō) far less cumbersome than Hong Kong. In addition to these Asian jurisdictions, locations such as the British Virgin Islands, Switzerland, and Seychelles are friendly and receptive toward crypto and digital asset businesses.       

Conclusion

In light of these alternatives, Hong Kong’s plan to woo crypto and digital asset businesses would seem to be a case of ‘too little, too late.’ It remains unclear if mainland Chinese investors will be able to trade tokens via Hong Kong.

American crypto firms seeking to establish a presence in Asia would probably do well to wait and see how Hong Kong’s new crypto regime unfolds. In the past, there have been issues related to the implementation of crypto-related laws in the city, especially regarding regulatory requirements and licensing. For now, it is clear that American crypto players hoping to benefit from Hong Kong’s new regime must apply to the SFC for recognition as VASPs. This in itself could be a monumental task, as the definition of VASP under Hong Kong law is ambiguous. In certain cases, American companies might find the licensing regime more relaxed in Japan. It is best to speak to a law firm specializing in emerging technologies, crypto, and digital assets to determine the optimal jurisdiction when it comes to establishing a presence in Asia. Gamma Law has a presence in both US and Asia and can advise on the best course available.

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Gamma Law is a San Francisco-based Web3 firm supporting select clients in complex and cutting-edge business sectors. We provide our clients with the legal counsel and representation they need to succeed in dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

FTX Investors Seek Damages from Athletes, A-listers

1000 648 Yusuke Hisashi

Will Civil Suits Against Celebrity Spokespersons Prove Fruitful?

The fallout from the FTX implosion may transport Steph Curry from the basketball court to US district court after the filing of class action lawsuit against the cryptocurrency exchange’s celebrity endorsers. Other high-profile athletes, including Curry’s fellow NBA’er , Udonis Haslem, ex-star Shaquille O’Neal, the NFL’s Tom Brady, (and his ex-wife model Gisele Bündchen) and Trevor Lawrence, MLB superstar Shohei Otani and hall of famer David Ortiz, and 4-time Grand Slam tennis champion Naomi Osaka have been named to the all-star defendant list along with Hollywood icon Larry David and investor Kevin O’Leary.

The $11 billion suit alleges that in putting their stamps of approval on FTX, this pantheon of pop culture are guilty of “misleading [users and investors] and encouraging people to get into their system and invest in the company,” lead plaintiff Edwin Garrison told Fox News. The suit says the endorsers are at least partially “responsible for the many billions of dollars in damages they caused Plaintiff and the Classes and to force Defendants to make them whole” because they “promoted… and actively participated in FTX Trading and FTX US (collectively, the “FTX Entities”), offer and sale of unregistered securities in the form of yield-bearing accounts (YBAs) to residents of the United States.”

The success of the lawsuit itself likely hinges on whether the courts consider the crypto offered on the FTX exchange assets that should be considered and subject to US securities laws. Gamma Law has addressed the arguments for and against treating crypto, NFTs, and other digital assets as securities.

Whether the endorsers will escape culpabilities in the eyes of the court, is another matter entirely. While the civil case could require years to unravel, the Federal Trade Commission (FTC)has made it clear that celebrity spokespersons and paid endorsers are fair game if their statements can be proven false of their actions can fraudulent.

Just as “advertisers are subject to liability for false or unsubstantiated statements made through endorsements, or for failing to disclose material connections between themselves and their endorsers,” the FTC’s “Guides Concerning the Use of Endorsements and Testimonials in Advertising, notes that “Endorsers also may be liable for statements made in the course of their endorsements.”

The FTC explains that even messages that are clearly marketing or promotional statements, consumers will recognize entities endorsing products by their celebrity or profession and “believe the celebrity’s statements represent his own views even though he is reading from a script. The celebrity is subject to liability for his statement about the product.”

So, depending on the evidence, FTX’s A-list may be in hot water with regulators. There have been several instances where celebrities agreed to pay fines and forfeit payments they received – and failed to disclose – for touting the spurious benefits of everything from diet supplements to real estate courses.

But do plaintiffs stand a chance of recovering their lost fortunes from these stars? In the most recent high-profile case, Kim Kardashian paid a $1 million fine and disgorged her $250,000 (plus interest) payment she received for touting the Ethereum Max token in a 22-word tweet. Kardashian fully cooperated in the investigation and agreed not to shill for crypto for at least three years. Despite this seeming admission of wrongdoing, she seems to have escaped liability in a civil suit claiming endorsements from her and boxing legend Floyd Mayweather Jr. led plaintiffs to pay “inflated prices” for the tokens in a pump-and-dump scheme. A judge’s tentative ruling indicates he will excuse Kardashian and Mayweather because the plaintiffs’ lawyers are “trying to act like the SEC [but] haven’t chosen to view the tokens as a security.”

The case follows a similar pattern in which the FTC disciplines endorsers, but alleged investors fail to recover damages. Interestingly, Mayweather’s Ethereum Max entanglement comes a little more than three years after he “agreed not to promote any securities, digital or otherwise, for three years,” as part of a 2018 SEC investigation. In that case Mayweather and music mogul DJ Khaled settled charges that they failed to disclose payments received for promoting three initial coin offerings. The SEC filed criminal charges against one of those ICOs were for “fraudulent and unregistered” tokens. The company’s principals pled guilty, were sentenced to prison, and surrendered more than $40 million in profits and interests. Mayweather paid over $600,000 and Khaled more than $150,000 in disgorgement, fines, and interest.

In announcing the settlement, SEC Enforcement Division Co-director Steven Peikin noted that “Investors should be skeptical of investment advice posted to social media platforms and should not make decisions based on celebrity endorsements. Social media influencers are often paid promoters, not investment professionals, and the securities they’re touting, regardless of whether they are issued using traditional certificates or on the blockchain, could be frauds.”

The plaintiffs claimed they would not have invested and lost money in the fraudulent ICO had they not been influenced by the celebrities’ enthusiastic endorsement of it, even though neither Khaled nor Mayweather knowingly participated in fraud.

Still, the boxer and the music producer were quickly dismissed from an investor lawsuit, with the judge in the civil case ruling that the plaintiffs failed to show they had been influenced by the celebrities’ endorsements, followed them on social media or even saw their tweets and Instagram posts.

Observers are closely watching the FTC’s case against Nudge, LLC and its celebrity spokesmen who made allegedly false claims about the company’s real estate investment training programs. The FTC’s filings say that Dean Graziosi, “a self-described New York Times best-selling author, entrepreneur, and investor,” and Scott Yancey, the star of reality TV’s Flipping Vegas,  used their influence in advertisements to “draw consumers into attending training seminars that falsely promised to teach consumers a proven formula to make money by investing in real estate.”

The case underscores the FTC’s endorsements and testimonials guidelines’ position that spokespeople can be held liable when they deliver statements that they know or have reason to believe to be false, even if they are simply reading from a script. In this case, the FTC charges that Graziosi and Yancey’s compensation came in the form of commissions based on consumer sales – to the tune of $10 million each – earned partly from the marketing campaigns that the celebrities helped devise. Further, the pair continued to endorse the real estate courses after becoming aware of numerous complaints about misleading claims, according to the FTC.

“They were instrumental to the scheme and took a cut of the profits,” said Andrew Smith, director of the FTC’s Bureau of Consumer Protection, in explaining the agency’s unusual tactic of including the endorsers in its case.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

SEC’s Bored Apes Probe – More Bad News for Crypto

1000 648 David Hoppe

Regulators Grow Bolder in Wake of FTX Saga

As if the crypto and NFT industry weren’t reeling enough in light of the FTX’s crash-and-burn, the U.S. Securities and Exchange Commission (SEC) is continuing its investigation into Yuga Labs Inc., the crypto company behind the (once) popular Bored Ape Yacht Club (BAYC), over its non-fungible token (NFT) collections and cryptocurrency.

According to Bloomberg, the probe seeks to determine whether some of Yuga’s digital assets operate and perform like stocks and are therefore be subject to the same disclosure and registration rules as publicly traded shares. The critical legal question at the center of the investigation is whether none, all, or some NFTs can rightfully be considered securities. The SEC reportedly has been pondering the issue at least since March. ApeCoin, Bored Aped Club’s native token, lost more than 10 percent of its value after news of the SEC investigation broke.

Yuga Labs has yet to be charged with any crime and the investigation does not necessarily mean that the SEC will file a lawsuit against the company. A spokesperson for Yuga Labs guaranteed that the company is cooperating with the investigation.

“It’s well-known that policymakers and regulators have sought to learn more about the novel world of web3,” a Yuga Labs representative said. “We hope to partner with the rest of the industry and regulators to define and shape the burgeoning ecosystem. As a leader in the space, Yuga is committed to fully cooperating with any inquiries along the way.”

The SEC declined to comment on what specific issues it is looking into or whether its concerns extend to other cryptocurrencies and platforms, though it did concede that it is “looking closely at all initial coin offerings (ICO)” in general.

Implications for NFTs and Cryptocurrencies

Multiple legal experts say the investigation could deal a crippling crucial blow to the NFT industry. They interpret the action as a clear signal that the SEC is taking unprecedented steps to solidify and uphold its dominion over the digital art marketplace. The agency may become even bolder in its quest for control over the industry. Many assume FTX broke its own policies and generally accepted best practices by co-mingling customer funds with its own and using those assets to prop up a sister company. The situation with FTX already sent congressional sharks circling the waters in quest of more stringent crypto and NFT legislation and governmental control.

Artist and NFT expert Alfred Steiner summed up the apprehension many minters and industry stakeholders are feeling about the SEC’s more aggressive stance in an interview with Decrypt.

“The potential for regulatory enforcement action is greater than I had anticipated, even with respect to NFT collections where each digital asset is unique,” Steiner said.

He said he is surprised that the SEC would target a blue-chip NFT collection like BAYC because the simians in Bored Ape NFTs in circulation are depicted with different visual traits (e.g., an earring, sunglasses, or a different colored background) that Steiner believes makes them appear less like securities and more like unique pieces of art.

“My impression prior to this news had been that the sort of diversity you have among digital resources in a collection like BAYC would be sufficient to keep regulatory action at bay,” he explained. “I don’t know of any previous signal that [SEC investigators] were going to do what they’ve done.”

However, other experts, including Brian Fyre, a law professor at the University of Kentucky, said the probe is long overdue.

“I’ve seen this coming for the last two years,” said Fyre. “What are all the different NFT collections that Yuga Labs is selling other than, functionally, investments in the future value of the Bored Ape Yacht Club brand? That’s all they really are at the end of the day.”

Fyre deems it reasonable for the SEC to open regulation of the space by targeting a famous NFT brand. People buy blue-chip NFT collections like Bored Ape BAYC solely because of their collective fame, not because of the artistic value of individual NFTs, which looks no different from buying shares in a company. People believe in blue chip NFT collections like Bored Apes because of their collective reputations, said Fyre, not because of the artistic value of individual NFTs.

“If you buy one of the Bored Ape BAYC series, then the value of your NFT will change as the value of the Bored Ape BAYC brand fluctuates,” he argues.

The Bottom Line

While the SEC currently does not have an official stance on all digital assets, SEC Chair Gary Gensler has repeatedly stated that cryptocurrencies are securities and should be subject to securities laws and the SEC has stated that XRP,  the native cryptocurrency on the Ripple network, is likely a security and that other currencies may also be subject to its jurisdiction. 

The implications of this for cryptocurrency exchanges are potentially far reaching. Any cryptocurrency that is deemed a security must be traded on a regulated exchange. All exchanges must comply with anti-money laundering laws, know-your-customer rules, and registration requirements—which can be time-consuming, expensive, and stifle innovation in this space. In addition, it’s possible that all tokens deemed securities must comply with strict disclosure requirements, which could effectively hinder their utility.

Given how the SEC’s investigations have expanded from ICOs to NFTs to cryptocurrencies, it may be that its involvement in these technologies has only just begun.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

EU to Launch Global Metaverse Regulation in 2023; Will the US Follow Suit?

1000 648 David Hoppe

The European Union’s (EU) “Thrive In The Metaverse” initiative for regulating the metaverse is intended to prepare Europe for the age of crypto and web3. What does it mean for European consumers, and is it likely that the US will follow suit and issue similar regulations?

Background              

The September announcement of the EU’s metaverse regulation framework is part of the continent’s digital regulation strategy, which examines new online opportunities and trends. According to Thierry Breton, European Commissioner for the Internal Market, any hype surrounding the virtual world or immersive social connectivity will be subject to scrutiny. Further, he said the commission will undertake steps to develop standards and increase interoperability in the metaverse market, as “no single private player should hold the key to the public square.” The commission aims to issue the metaverse regulation in 2023. It is anticipated that the EU’s metaverse regulation will cover three topics in particular:

  1.  Network Infrastructure Taxes
    It is likely that the EU’s metaverse regulation will introduce network infrastructure taxes on network providers. According to Breton, some of the profits made in an increasingly immersive software realm should flow to providers of the networks that serve as the backbone required to host these virtual spaces. If implemented, this provision is likely to prove controversial.
  2. Rebooted Digital Rules
    Judging from EU President Ursula von der Leyen’s ”Agenda for Europe,” new rules may be put in place to implement the landmark agreements contained in the Digital Markets Act (DMA) and the Digital Services Act (DSA). These acts saw the EU take global leadership in regulating the digital space to make it safer and more accessible.
  3. Safety and Interoperability Measures
    From Breton’s remarks, the EU appears poised to issue regulations related to user-centric safety issues, especially those related to content moderation, and to ensure that platforms remain open and contestable to the whole market via interoperability standards mandates

Indications are that the EU will adopt a blended approach to the metaverse and virtual communities. It will offer support initiatives to encourage development and infrastructure but take a more active role in shaping the development of the metaverse. This type of blended approach is likely to ensure that new forms of immersive technologies do not experience the same toxic growth exhibited by Facebook.

Implications for the Metaverse in America

In the United States, there has been no announcement per se on unilateral regulation of the metaverse. The consensus seems to be that, at least in the short term, self-regulation is the preferred policy, with the onus on the “most reputable players” in the metaverse to join forces, draw up their own code of conduct, and create a set of best practices. In the long term, Washington may issue an all-encompassing metaverse regulation after consulting with key stakeholder groups and representatives from participating industries. In the meantime, regulators in this country have delivered mixed and fragmentary messages:

  1. FTC’s Statement on Meta’s Acquisition of Popular Metaverse Application
    The most direct US regulatory development on the metaverse is the Federal Trade Commission’s lawsuit to block Meta’s acquisition of a popular metaverse application. The FTC is seeking to stop virtual reality giant Meta and its controlling shareholder and CEO Mark Zuckerberg from acquiring Within Unlimited and its popular virtual reality dedicated fitness app, Supernatural. This lawsuit is still ongoing, and it seems only a matter of time before the US government issues new guidelines or laws on how the metaverse will be regulated.
  2. Data Privacy Laws
    Earlier this year, Representative Suzan DelBene (D-Wash.) pushed for a bill to enact a federal data privacy law. The Information Transparency & Personal Data Control Act is a comprehensive consumer data protection protocol that would put people back in control of their data, require companies to publish end-user policies in clear language, and establish strong enforcement mechanisms to protect all Americans. If enacted, this bill might take effect sometime in early 2023.
  3. Antitrust Reform
    In 2021, the House Subcommittee on Antitrust, Commercial and Administrative Law released five bipartisan bills that would hold big tech companies accountable for alleged anti-competitive conduct. These bills were drafted after a 16-month investigation that suggested that big tech companies are using their near-monopoly powers to crush competition and innovation. Further, senators John Kennedy (R-La.), Amy Klobuchar (D-Minn.), and Chuck Grassley (R-Iowa) introduced an antitrust bill known as the American Innovation and Choice Online Act to stop big technology companies from limiting consumer choice. The aim of this bill is to restore online competition by establishing common sense rules for digital companies. These rules are intended to prevent abuse of dominant market power and to foster competition in the market. These reforms are also likely to come into force sometime early next year.

Conclusion

Countries in the EU, South Korea, and Japan have made significant strides toward regulating the metaverse. While the US has yet to issue a comprehensive framework or law on the metaverse, the scope and breadth of discussions on the topic of regulating the metaverse are quite extensive. It is best to consult an attorney specializing in emerging technologies to get an idea about these regulatory developments as it may have an impact on your business.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Apple Store Allows NFT Sales; Takes Its Slice of the Pie

1000 648 David Hoppe

As part of its new guidelines for the App Store, Apple has announced that it will allow developers to sell NFTs within apps and games. Despite the limitations and fees Apple attaches to certain types of NFT, this is a big deal because, as DigiDaigaku NFT project founder Gabriel Leydon tweeted, “…this could put an ETH wallet in every single mobile game onboarding 1B+ players!”

Apple’s New NFT Policy

Users can now sell and trade NFTs through a number of apps available on the Apple App Store. Apps that store or display NFTs may have been breaking Apple’s rules before this decision. In September 2021, Gnosis Safe, a crypto wallet that helps users manage and even sell digital assets on Ethereum, had been offering its app in the store for several months when it received notice from Apple that “Apps that access, whether it is just simple storage or marketplace, are not appropriate for the App Store. We suggest you remove this feature from your app.”

Developers can now sell NFTs with Apple’s approval. However, the company imposes the same monetization structure to NFT sales as it does to other App Store purchases: a 30 percent commission from app developers who earn over $1 million annually through the ‌App Store‌ and 15 percent from smaller sellers. Apple says apps can list, mint, and transfer NFTs and provide a mechanism for users to view their NFT collections as long as they do not unlock additional gameplay features or functionality within the app. Apps also can promote other NFT offers as long as they do not provide external links or purchase media that circumvent Apple’s payment system.

While it is one of the largest technology companies in the world, the Cupertino giant has done little to embrace blockchain technology, and its products are criticized for being too closed-off. This new development indicates that, while progress is slow, Apple is warming up to blockchain technology and its applications. 

Apple’s 30% Solution Remains Controversial

Apple’s hefty commission tag has drawn criticism from the global crypto community and drawn contrasts to several other NFT markets. OpenSea and Magic Eden’s commissions hover around 5 percent; others have kept their transaction cost threshold as low as 2.5 percent.

Tech blogger Florian Mueller called Apple’s “app tax” on NFT sales “abusive but consistent”, adding that the actual costs to developers can frequently exceed the 30 percent commission cited when referencing the App Store, as some geographic regions are subject to fees as high as roughly 35% in addition to other fees applied to running search ads. 

Persistent Apple critic, Epic Games CEO Tim Sweeney, also tweeted that Apple is “crushing” another nascent technology that “could rival its grotesquely overpriced in-app payment service,” and that Apple’s exorbitant fees could suffocate the entire NFT sector.

Apple’s commission policy is the basis for Epic Games’ lawsuit against Apple, which has been ongoing since 2020. The video game publisher sued Apple for not allowing it to use its payment platform instead of the App Store’s in-app purchases and for taking a 30% cut.

Challenges With The Secondary Market

Magic Eden, the largest Solana NFT marketplace, also needed clarification on the move, declining in-app trading support after hearing intense cost demands from Apple. “Our app remains available in the App Store as a tool showcasing Magic Eden listings and mints, but it does not have trading support,” a Magic Eden spokesperson said.

Secondary NFT sales are also problematic. Magic Eden and OpenSea, for example, typically charge a commission of no more than 5%.

“In this case, if a collector wants to buy an NFT through the Magic Eden or OpenSea app on an iPhone, the seller will only receive 70% of the purchase price,” Blockwork explained. “And the marketplace is unlikely to be interested in making up the difference.”

Apple’s decision to allow NFT sales at its standard premium is a significant roadblock for NFT startups. Several startups have complained about the rules Apple allegedly imposes, and that the fees make using the App store difficult to justify.

While a court decision last year required that Apple allow links to off-platform payment channels, this may not be relevant for NFT trading because Apple does not accept cryptocurrency payments. All item listings are in dollars and are paid in fiat. NFT marketplaces face the challenge of constructing additional infrastructure to support Apple’s payment system, and NFT dollar prices are constantly changing due to cryptocurrency volatility.

Few Blockchains Can Scale To Meet Apple’s User Base

But not all Web3 companies have balked at Apple’s policy. Some see benefits to Apple’s NFT acceptance because the market and Web3 apps available in its store gain the potential to achieve mass adoption. In addition, a 30 percent commission to Apple is better than being prohibited from the App Store altogether.

Apple can attract hundreds of millions, if not billions, of people to NFTs and crypto by validating crypto and NFTs. The gaming industry, home to approximately 4 billion online players right now, is another sector that could generate large commissions. By current estimates, fewer than 100,000 people play cryptocurrency games, so the integration into iOS apps could bring in thousands or millions of new users.

Conclusion

Apple’s decision to allow developers to sell NFTs in its App Store may be portentous. Apple has traditionally been very protective of how its platforms are used, and this move could be interpreted as a sign that it is beginning to loosen restrictions and open to other types of apps and services. Everything from blockchain-based games to decentralized social networks could fall under this category.

This news has been interpreted as exploitation of an emerging industry as well as the green light for Web3 applications to branch out from being the sole province of Android. The truth is that it is both. While this may not be the most significant development in the crypto space, it does show that Apple believes in the technology and wants to help it progress. Finally, it remains to be seen how Apple’s decision will impact the nascent crypto app ecosystem and the blockchain industry. For example, gaming may now find a niche within the expanding ecosystem, with developers encouraged to create more diverse games and users willing to invest more time and money into the blockchain world.

This new allowance for NFTs represents a significant step toward decentralizing digital data for a company that has long been obsessed with protecting its bottom line. It also demonstrates that Apple is taking notice of what blockchain offers.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

N(o) F(reaking) T(hanks): The Backlash against NFTs in Video Games

1000 648 David Hoppe

Video games are historically a driving factor in the development of new technologies. When the crypto-based assets known as non-fungible tokens (NFTs) first arrived, video game developers embraced them with lightning speed. In what seemed like overnight, many PC and console-based video games announced they would incorporate NFTs into their platforms to expand the gaming universe and increase revenues. At first blush, it was an interesting and novel idea. Unique active wallets in blockchain gaming grew by 2,000 percent and won $2.5 billion in investment over the 12 months ending in March 2022. Gamers seemed intrigued by the opportunity to purchase NFTs to improve their in-game characters with skins, tools, and other items, but opposition arose shortly after NFTs began appearing in games. This increasingly vocal opposition continues to push back against gaming companies for even announcing plans to plug NFTs into games.

So, What Happened?

Some gamers became incensed at the idea that NFTs would force them to pay to unlock features they believe should be included with the price of the game purchase. Others maintained that grinding for the resources required to obtain in-game NFTs would rob many games of their fun. Many players view the incorporation of NFTs into video games as yet another predatory attempt by gaming companies to squeeze more money out of players. They clashed with Ubisoft, Square Enix, Zynga, and other major game developers over the introduction of NFTs and crypto into their favorite titles.

Many gaming companies, on the other hand, view NFTs as a means for verifying digital assets on the blockchain, conveying proof of ownership that players can sell for a profit in online marketplaces. Gaming companies claim that incorporating NFTs into the games helps build community and “play to earn” opportunities and take the position that NFTs support game players and NFT artists. Many gamers remain unconvinced, especially those still smarting from bad experiences with downloadable content (DLC) or loot boxes. Despite game companies’ attempts to draw distinctions by citing blockchain benefits and resale values, an extremely vocal contingent of gamers remains steadfast (this is very much reminiscent of the situation surrounding World of Warcraft in the early 2000s).

NFTs can offer exclusive in-game assets or highly sought-after items, making them potentially worth thousands of dollars and well out of reach of the average gamer. Far from democratizing and making gaming more inclusive, NFTs might reward players who can afford to “pay-to-win,” making the playing field more unequal than ever before. Further, some game enthusiasts fear the introduction of valuable NFTs could cause the price of games to increase dramatically, excluding even more potential players from the “community” and diluting the experience.

As if this weren’t enough, gamers have expressed significant concerns over scams, thefts, and hacks targeting NFTs and their owners. Illegal activities surrounding NFT transactions, such as those that launder money. The gaming industry is already a breeding ground for scams, spam, and fraud, and many gamers believe NFTs will only further attract the worst elements of society. The NFT marketplace isn’t regulated strictly, so the threat of gamers being cheated is real. The marketplace Itch.io gave voice to the anti-NFT contingent in a tweet slamming the NFT craze, calling it a “scam,” “get rich quick” scheme, and an avenue for dubious parties to exploit gamers. Security issues abound, such as the hacking of the blockchain of Axie Infinity uses where hackers stole $625 million. 

Gamers also decry the negative environmental impacts NFT minting and the blockchain inflict on the world. Ethereum, the main blockchain platform for NFTs, releases the same amount of carbon dioxide emissions into the atmosphere as the entire country of Libya. The enormous amount of energy consumption that occurs when minting, buying, and selling an NFT produces carbon dioxide emissions that cause climate change. NFTs’ carbon footprint is significant—the sale of one crypto art consumed 8.7 megawatt-hours of energy, the equivalent to two years’ use of energy in an artist’s studio.

NFTs Still the Future of Gaming?

Some gaming companies have acquiesced to the anti-NFT crowd and a few even agree with their view. Electronic Arts (EA), Team17, and Epic Games, have pumped the brakes on their NFT initiatives. Discord, STALKER 2, and MetaWorms canceled their NFT projects after being subject to backlash from gamers. Steam has banned all cryptocurrencies and NFTs from its online gaming platforms. Mojang’s July 2022 announcement that it would ban NFTs from its wildly popular Minecraft game sent shockwaves through the gaming and NFT communities. Citing a desire to foster a safe and inclusive experience for its players, Minecraft has prohibited the integration of blockchain servers. 

Despite several gaming companies abandoning, or at least taking a step back from NFTs,  others continue to embrace them. 

Perhaps they are banking on attracting the “silent majority” of gamers who are intrigued by the potential of earning NFTs from their activities. A survey of 1,500 players earlier this year revealed that only 23 percent were “not interested” or “not very interested” in play-to-earn NFTs. In fact, the poll revealed that more than two-thirds are already doing so, including 4 percent who are using video games to build their NFT collection and another 12 percent who have already monetized their play by selling NFTs they have earned. According to Interpret, the firm distributing the survey, “NFTs could play a major role in retention (of critical importance to live-service games), as over 45 percent indicated that being able to earn NFTs through gaming would increase their current engagement levels with games. Ultimately, Interpret expects gamer sentiment to continue to warm towards “play-to-earn” as the industry unpacks how best to position this new model. NFTs represent a shift in power to the players and provide a greater sense of true ownership from the items they earn both in and out-of-game. ”

Conclusion

Gaming companies will have to figure out the balance of using NFTs to enhance gaming experiences while compromising the experience for gamers who can’t or refuse to utilize them. Due consideration of players’ security and support needs as well as minimizing environmental impact will certainly help improve the outlook for NFT in gaming. Significantly, GameStop is moving ahead with its NFT marketplace. Others, like NFT World, which sold NFTs that fit into the Minecraft world, have committed to exploring other options, including developing a Minecraft competitor. But for now, a reckoning has arrived for the otherwise burgeoning crypto-based gaming market. While the gaming and NFT worlds are still evolving, game companies’ romance with NFTs may have cooled for the foreseeable future. 

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Regulators Leaning Toward Treating NFTs as Securities?

1000 648 David Hoppe

Recent legal developments in the US and elsewhere seem to point toward the eventual classification of NFTs as securities. Should the trend continue, these rulings and regulations are sure to have important consequences on the video game industry and on emerging technologies companies aiming to launch their own NFTs in the near future. 

Background

Just how NFTs should be regarded by law enforcement, tax collectors, and financial regulators has been the subject of debate for almost as long as there have been NFTs. They can be owned, so are they private property? They have to be created, so are they art? They can be bought and sold freely on a number of markets, so are they commodities? And they can often accrue significantly higher value than their purchase price, so are they investments? Any digital asset, including NFTs, can be classified as “securities” by the US Securities and Exchange Commission or similar regulatory bodies in other countries. In the US, however, one court case has set the precedent under which NFTs act as securities and therefore should have to follow the rules established for these financial instruments.

The US Supreme Court, in the SEC v W.J. Howey (Howey) laid down four elements to determine whether digital assets such as cryptocurrencies or NFTs could be considered a “security” or “investment contract”:

  1. An investment of money…
  2. into a common enterprise…
  3. in which investors expect to profit…
  4. from the efforts of third parties.

Any NFT that fulfills these four conditions is likely to be deemed to be a security by the SEC. The primary responsibility of regulating NFTs lies with the SEC and Commodity Futures Trading Commission (CFTC) under federal securities law. In addition, each state has its own securities law, which may have different or additional requirements to those of the federal securities law.

Several moves by regulators and private citizens are poised to make a clearer delineation of when NFTs and other digital assets stray into securities land:

  • Lawsuit over NBA Top Shot Moments
    A Virginia resident filed a class-action lawsuit on behalf of anyone who has purchased NBA Top Shot Moments. The case accuses NFT creator Dapper Labs and the NBA of marketing and selling “unregistered securities.” The plaintiff has alleged that NBA Top Shot Moments (digital video basketball cards) pass the Howey test and should be subject to the Securities Act of 1933. Dapper Labs responded with a motion before a Manhattan court requesting that the court dismiss the lawsuit as its digital basketball cards are simply collectibles like any other sports trading cards, coins, or stamps. The case is pending, and the final decision is likely to shed light on a number of issues related to the legal status of NFTs as securities.
  • SEC Scrutiny over Illegal NFT Offerings
    Around the middle of the year, the SEC started scrutinizing NFT creators and crypto exchanges for securities violations. The scrutiny has been specifically geared toward ascertaining whether certain NFTs are being utilized to raise money like traditional securities. The SEC is particularly interested in fractional ownership of NFTs, which it believes looks a lot like owning shares in a company or project. Selling small pieces of more valuable NFTs is a big part of New Jersey-based crypto lending company BlockFi’s business model. The SEC has ordered BlockFi to pay a record fine of $100 million for failing to list its “high-yield” lending products as securities. More action could be forthcoming in light of SEC Chairman Gary Gensler characterization of “the vast majority” of the nearly 10,000 tokens in the crypto market as securities.
  • Litigation against Former Open Sea Executive
    Former Open Sea executive Nate Chastain has been charged with insider trading – a phrase and an offense reserved for people accused of using proprietary information to buy or sell company stocks or other securities. It can be argued that the attempt by the Department of Justice (DOJ) to charge Chastain with insider training is actually an attempt to label at least some of the NFTs on the Open Sea marketplace as securities. OpenSea has instructed its employees to avoid using securities-related words such as “trading” and “derivative” when talking about the platform’s NFTs.
  • Yuga Labs Threatened with Class Action Lawsuit
    Bored Ape Yacht Club (BAYC) creator Yuga Labs was threatened with a class action lawsuit for “inappropriately inducing” investors to buy BAYC NFTs and ApeCoin. A law firm has alleged that Yuga Labs used celebrity promoters and endorsements to inflate the price of its NFTs by overpromising returns. They further alleged that this was in contravention of the US securities law
  • Regulatory Action Sand Vegas Casino Club
    In April 2022, securities regulators in Texas and Alabama issued a cease and desist order against Sand Vegas Casino Club, a Cyprus-based virtual casino developer, to stop selling NFTs on the grounds that they are unregistered securities. The states found that the company failed to take several important steps such as registering a physical address, warning against the risks of operating a casino, and registering the NFTs with the states in marketing the NFT to consumers and prospective investors in its metaverse and online gambling site.
  • Proposed Crypto Bill
    In June 2022, US senators introduced a bipartisan bill calling for new rules on cryptocurrency and bestowing the bulk of the responsibilities for regulating NFTs on the CFTC. If the bill passes, the CFTC and not the SEC will be responsible for regulating crypto products since the authors believe the currencies are more likely to operate as commodities than as securities. While the proposed bill does not explicitly mention NFTs, it is likely to be applied to them. This bill is expected to be discussed in the senate sometime early next year.  

These legal developments suggest an increasing push in the US to categorize certain NFTs as securities. The legal categorization of NFTs as securities will have a huge impact on the video game industry and on emerging technologies companies aiming to launch their own NFTs as it would require potentially onerous compliance with the US securities law. Non-compliance can attract heavy penalties, therefore it is best to consult an NFT lawyer about the legal status of NFTs before embarking on an NFT project. A consultation can prevent legal liability down the road.  

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Defining NFTs: Property, Securities, or Commodities?

1000 648 David Hoppe

The legal classification and regulatory environment for NFTs remain unclear, making it difficult for Web3 developers, video game publishers, and metaverse architects to be fully confident they can employ NFTs without inviting lawsuits or government investigations. Some semblance of clarity, however, may be on the horizon, as US courts in the near future will decide several potential landmark cases, regulators deliver commentary that hints at pending rulings, and industry groups weigh in with suggestions for self-policing.

Securities, Commodities, or Property?

Defining NFTs’ status among personal and business assets is a logical first step in determining whether and how they should be regulated. Some experts are convinced that NFTs constitute securities because they act as investment instruments. People purchase them in the hope that their uniqueness and scarcity will drive up their value so they can be sold at a profit.

Several high-profile court cases hinge on plaintiffs’ contention that NFTs are securities. The US Department of Justice has accused Nate Chastain, a former OpenSea executive, of insider trading based on confidential information about upcoming issuances that OpenSea would promote. The government alleges that he purchased many of those NFTs in advance and profited when the ensuing publicity on the platform increased demand and drove prices higher. Chastain’s attorneys argue that even if Chastain did as the DOJ alleges, he should not be prosecuted because his actions would not constitute criminal activity. Insider trading, they say, is only illegal if it is done using stocks or other securities and NFTs are not securities. In this view, Chastain’s actions may be the definition of workplace misconduct, but they do not rise to the level of a federal felony.

Many business models adopted by video game and Web3 companies leverage the collectibility of NFTs. That’s the premise behind NBA Top Shots Moments. The National Basketball Association contracted with Dapper Labs to distribute the Moments, which are video clips from NBA games. The value of Moments with low serial numbers, featuring stars of the game, and capturing stellar plays consistently rises to well above their initial selling price. A class action lawsuit alleges that Dapper Labs violates US securities law by actively promoting, offering, and selling the NFTs. Plaintiffs argue that Dapper Labs failed to comply with the securities disclosure requirements, downplaying the investment risks involved and inducing uninformed purchases. Dapper Labs counters that Moments are not investments but rather simply digital basketball cards offered to fans and collectors.

Finally, a Senate bill would classify most NFTs as commodities and weaken the Securities and Exchange Commission’s oversight powers. The bulk of regulatory duties instead would fall to the Commodity Futures Trading Commission, whose mission is to protect buyers, sellers, and the public from fraud, investigate misconduct and minimize the risks inherent in derivatives transactions. Categorizing NFTs as commodities would impose strict disclosure requirements, trading guidelines, and marketing standards upon sellers. Companies that allow buyers to obtain NFTs on margin or through leveraged accounts would have to operate on registered exchanges or make physical delivery of the NFT and/or the asset tied to it within four weeks of purchase.

The outcome of these court cases and the fate of the Senate bill will further define how NFTs are regulated, taxed, and transacted.  

AML / KYC

According to a report issued by Elliptic, a London-based blockchain analysis company, over $540 million in crypto proceeds were processed through money laundering schemes over the last two years, including over $153 million that allegedly originated from ransomware payments. The study found that 22 NFT marketplaces, 4 NFT-based games or metaverse platforms, and 2 NFT swap services were being investigated for money laundering.

In February 2022, the United States Department of the Treasury (the Treasury) issued a Study of the Facilitation of Money Laundering and Terror Finance Through the Trade in Works of Art. The report discusses how the high-value art market, including certain NFTs, is vulnerable to financial crime and susceptible to abuse by bad actors. It also makes recommendations for art market participants to implement and maintain anti-money laundering/countering financing of terrorism (AML/CFT) programs. Similarly, in April 2022, a consortium of governing bodies, including the Internal Revenue Service, issued warnings to banks, legal authorities, and private collectors about the growing money laundering and fraud risks surrounding NFTs. This consortium is known as the Joint Chiefs of Global Tax Enforcement and was formed in 2018 to share intelligence and combat transnational tax crimes. Given these developments, it is likely that the US will require KYC measures to fight money laundering related to NFTs in the near future.

Intellectual Property

It is well established that buying an NFT does not grant ownership over the underlying asset, unless that transfer is expressly stated in the smart contract that enables the transaction. In fact, according to a recent study conducted by crypto merchant bank Galaxy Digital on the NFT marketplace, Web3’s promise of digital ownership and property rights “remains far off.” The study found that the vast majority of top NFT collections do not convey any form of intellectual property or ownership of underlying artwork or media. Nonetheless, this has not prevented many NFT buyers and sellers from trying to convince themselves and others that owning a screenplay, a handbag, a shoe, or some other possession grants them the right to mint digital assets based on them.

For example, Miramax sued to prohibit Quentin Tarantino from selling NFTs based on Pulp Fiction. The studio’s recently-settled suit noted that simply having written the screenplay does not convey IP rights to Tarantino to the movie. Tarantino’s view was that the NFTs were derivative of the screenplay, not the production.

Several other cases pertaining to NFTs and IP loom. Courts will decide a host of thorny NFT issues related to trademark infringement, copyright, and right of publicity. The recent spate of litigation pertaining to NFTs and IP suggests that new regulations may be required to address how innovators are employing NFTs in gaming and virtual worlds.

Privacy

The blockchain on which NFTs are based is a public ledger, which means that anyone in the world can view its contents. The blockchain is also immutable: information contained within it cannot be altered or deleted. These factors give rise to significant privacy and data protection concerns related to NFTs. Hackers could potentially use NFT transactions to steal users’ blockchain addresses, financial activity, physical location, metaverse avatars, and more.

Given the dynamic and relatively young state of gaming, metaverse, and other digital technologies, there are no laws that specifically tackle privacy and data protection over the blockchain. Current data protection laws in the US and other countries are inadequate to address privacy-related challenges posed by the increasing use of NFTs. For example, the fact that data cannot be deleted from the blockchain runs contrary to basic data subject rights under the California Consumer Privacy Act. It seems likely that the US will eventually introduce new laws to reconcile these disconnects.  

Conclusion

As an emerging asset class, NFTs and their marketplaces require a new set of guidelines and rules for consumer protection, particularly with regard to NFTs’ classification, IP ownership, and security.

In order to avoid or minimize legal risk, game publishers, metaverse developers, and web entrepreneurs should protect themselves by speaking with an attorney before embarking on any NFT project.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Sell the Sizzle, Not the Stake: Marketing NFTs

1000 648 David Hoppe

Numerous celebrities, musicians, athletes, and other influencers have invested in NFT artwork and technology, whether for their personal use or for building the next stage of their brand and empire. Concurrently, NFTs have evolved from the exclusive domain of digital artists to become major marketing tools for companies like Twitter and Warner Bros.

Investors and consumers alike have been captured by the non-fungible token craze, which skyrocketed in 2021 with about $44 billion worth of crypto sent to NFT smart contracts on the Ethereum blockchain – an exponential increase from 2020’s $106 million. Sales reached a record high of $6.13 billion in January 2022 before coming back to Earth in the following months.

Still in its nascent stages, the NFT market presents some real legal and regulatory issues that are complicated by confusing jurisdictions and the application of laws designed for more traditional investments and technologies. Some investors and attorneys deem NFTs to be shielded from securities and investment laws, but other fintech lawyers and Securities and Exchange (SEC) experts warn that NFTs are increasingly blurring the lines.

NFTs Are Not Considered Securities…Yet

NFTs are typically thought of as collectibles, like pieces of art or baseball cards, and they are non-fungible, meaning that each NFT is a one-of-a-kind asset. NFT creators can set the sales price and the maximum number of items that can be produced, as well as explicitly state which, if any, licenses NFT ownership conveys, and how royalties are to be paid in their smart contracts.

Transactions involving NFTs don’t need intermediaries for sales because they can be sold peer-to-peer or in an NFT marketplace. However, NFTs can be linked to a variety of aesthetic and intangible assets, including digital art, video clips, and game items. They are registered on the blockchain and possess their own unique, digital “fingerprint.” NFTs can also be tied to other assets that can be digital or physical as determined in the smart contract. Use cases to date have included physical art pieces, rare wines, concert performances, real estate, and more.

Initially, NFTs were marketed and sold as single lots but now more are being fractionalized to allow for shared ownership. What might have begun as a single collectible now may start to look like a security or share of stock in an investment, especially when the NFTs lean towards more brand-based collections. While NFTs are non-fungible, the smart contracts tied to them and the terms contained therein may make them less fungible, such as in cases whereas one “share” of an NFT accrues the same royalties, profit sharing, and profit upon resale as any other share. If an NFT transaction triggers cryptocurrency or security regulation, creators and owners may need to demonstrate that the assets involved are non-fungible in order to avoid legal hot water and unfavorable tax treatment.

Non-fungibility and the ability to pass the three-pronged Howey test are not always mutually exclusive. The process is case-specific and the devil is in the details when it comes to determining whether an asset is an investment contract. Howey indicates that something is a security when the purchaser invests money in a common enterprise with the expectation of making profits through the efforts of someone else. The Howey test applies to any contract, scheme, or transaction regardless of whether it appears to be a traditional security.

NFT Staking

Staking NFTs has become more popular in recent years. Staking is a way to put a unique NFT on the blockchain and into the marketplace. When an NFT is staked, it’s attached to a platform or protocol. In exchange for allowing his or her NFT to be used as “proof of stake” (POS) in crypto mining operations, the NFT creator earns rewards as well as other unique benefits.

NFTs can also be staked in similar fashion as cryptocurrency. Using a smart contract or appropriate blockchain protocol and a suitable crypto wallet, NFT stakers lend their assets and in return receive a percentage of their worth (similar to bond investing) and other benefits as determined in the relevant smart contract. The owners retain ownership of the NFT and reclaim possession at the end of the contracted staking period.

Similar to DeFi lending, NFTs can earn passive income when staked on a blockchain based on the annual percentage yield, the staking period, and the unit or quantity of NFT being staked. Many NFT owners take this approach to earn passive income instead of selling their NFTs, which disposes of their assets and often takes time to complete (the “illiquidity” problem). NFT lending relies on a POS mechanism to reward participants (the stakers). NFT owners might stake their assets to access crypto loans according to an agreed-to loan value (LTV) ratio or to obtain hard-to-buy or rare video gaming items.

While NFT staking is still in its infancy stage, it functions as a key bridge between NFTs and the DeFi economy. With the growing popularity of NFT staking, owners need to be aware of potential securities issues. Staking could be considered a securities scheme (failing the Howey test) unless the NFTs involved demonstrate utility and the marketing is aimed at that utility rather than the possibility of financial gain. The SEC has begun to investigate certain crypto exchanges for violating its rules. BlockFi received a $100 million fine for failing to register products it uses to pay customers for putting their digital tokens up for lease. In particular, the SEC is gathering information regarding fractional NFTs to determine where exactly they fall on the regulatory spectrum.

Keeping NFTs in the Non-Security Realm

Investors and minters interested in NFTs should be aware of growing government scrutiny of NFTs, including staking and fractionalization of NFTs. Most whole, unique NFTs assets are unlikely to be considered securities. However, fractional NFTs will likely receive closer scrutiny by the SEC for appearing and acting more like securities than traditional NFTs, especially if the owners are expected to receive profits, the money is used to build a platform, or if the NFT acts a license to another digital asset and will receive a share of attributed revenues. Marketing fractional NFTs as assets that will generate profits places emphasis on the potential for investment returns based on the NFT promoter’s ongoing efforts as compared to the consumptive value of the NFT as a digital asset.

Owners and creators of NFTs will want to avoid financial penalties and reputational damage from violating SEC rules. Working with an attorney who understands the current and upcoming regulatory conditions can help NFT creators and owners avoid potentially violating SEC rules and enjoy their unique digital assets.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

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