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.
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”:
- An investment of money…
- into a common enterprise…
- in which investors expect to profit…
- 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.
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