Are NFTs securities? Should you be concerned?
Some legal issues to consider before creating or buying into an NFT project
Hooray! You’ve just won a spot for the latest animal generative NFT project! Is it great news, or will your crypto “investment” become an albatross ensnared in legal issues?
Last week Bloomberg reported the SEC is looking into NFTs running afoul of US federal law as potential unregistered securities.
How can a digital image be an unregistered security?
Ethereum was the first blockchain project to introduce the ability to use smart contracts with cryptocurrency. This technology creates a decentralized computer that automatically follows the contract rules.
NFTs use this technology for transactions like recording ownership or allowing transfer of the NFTs to other owners. An important concept to understand about NFTs is that the actual “thing” you own is NOT a digital picture, but instead is a record (which is like a receipt) that is written on a blockchain.
However, smart contracts can do more than just create a record of a transaction! In fact, smart contracts can be written to automatically do all kinds of things like split royalties and send them to different addresses, change your NFT in some form, charge rent, pay interest, and much more.
Smart contracts also can be easily used to create your own cryptocurrency or token. Many thousands of tokens have been created in smart contract ecosystems and serve many different purposes such as cryptocurrencies, social tokens, and utility tokens.
Getting Punk’d
Exciting projects have sprung up using these tokens in different ways and even incorporate NFTs.
Perhaps paying $200k for a CryptoPunk is unimaginable, but what if you could pay $20 for a fractional interest in a CryptoPunk?
Sites like fractional.art have implemented smart contracts allowing users to transfer NFTs into the contract and in return issue tokens that represent shares in the NFT portfolio. The tokens are then sold to the public through the smart contract.
Seems like a great way to invest in a “blue chip” NFT portfolio, right?
This is where the SEC and U.S. securities law enters our picture.
In 1946, the U.S. Supreme Court ruled on SEC vs. Howey Co, and boiled down the definition of a security to be “an investment of money in a common enterprise with profits to come solely from the efforts of others; and, if that test be satisfied, it is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value.”
This ruling created a basic test to determine whether something is or isn’t a security, known as the Howey Test.
So back to our fractional NFTs: do you think the tokens issued represent an investment in a common enterprise? This is the question the SEC is looking into according to recent news:
As part of its review, the SEC is seeking information on so-called fractional NFTs, which involve breaking down the assets into units that can be easily bought and sold, said the people, who asked not to be named as the probe hasn’t been disclosed publicly.
It’s very possible the fractionalized NFT sales could be seen as unregistered securities offerings and the companies creating these sites fined or disbanded. However, there is a bigger issue here and it dovetails into how the U.S. will regulate blockchain-related technologies. President Biden signed an executive order exploring regulation and use of cryptocurrencies today.
Hopefully we’ll gain clarity on the issue of blockchain-related securities versus non-securities, however I think the road ahead is quite rocky.
Blockchain technology by its nature is decentralized and not controlled by any “common entity.” Sure, companies or people can heavily influence a project. But circling back to our fractional art example, the fractional.art website could be removed and the company disbanded, but the smart contract would remain on the blockchain and anybody could still interact with it.
While regulation of the crypto space is inevitable, incorrect or overregulation could drive these technologies underground and stifle innovation.
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Join us here. We’ll be talking about NFT news and topics, and we’re glad to answer your NFT questions!