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.
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.
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