We’ve got another deep dive post for our readers. We encourage you to join us as we think creatively about non-fungible tokens (“NFTs”). Here’s what we plan to cover in this part one of a two-part post:
- What’s fungibility?
- What’s an NFT?
- How are U.S. securities laws being applied to NFTs?
- How should NFT developers be reacting to recent cases by the SEC?
- Are royalty interests being treated differently today as NFTs compared to the past?
What’s fungibility?
First, fungibility is a way to describe something that is identical to something else such that they are deemed to be mutually interchangeable. The easiest example is the U.S. dollar. If Alice holds a single U.S. dollar in her hand and Bob holds a single U.S. dollar in his hand, they have neither gained nor lost anything by swopping dollars with each other. Hence, when you already have money in your bank account, money that is received for one purpose can easily be used for another.
In the world of digital assets, tokens can be fungible or non-fungible. Bitcoin and Ether are examples of fungible tokens that serve as a unit of account for their respective blockchains. This is substantially similar to how U.S. dollars serve as units of account for goods and services bought and sold in the U.S. economy.
So, what is an NFT?
In a previous post, we used the analogy of digital music files. There we said the following:
Blockchain technology represents an innovation that solved the digital world’s problem of scarcity and title transfer. Go back to the days of Napster and music mp3 file sharing. If Alice wanted to sell her mp3 of Unchained Melody by the Righteous Brothers to Bob, there was no [effective] way to ensure title transfer and enforce scarcity in the digital world. In the analog world, Alice owns a vinyl record of the single, Unchained Melody. Bob gives Alice $3 and Alice gives Bob the vinyl. Scarcity is enforced because another copy of the vinyl was not created and title transfer was enforced because Alice can no longer play the vinyl because Bob owns title and possesses the vinyl to the exclusion of Alice. In the digital world, the equivalent of these steps could not occur because copies of mp3’s are easy and cheap to make, Alice gives Bob a copy of her Unchained Melody mp3, keeps a copy for herself, Alice and Bob can both listen to the mp3, scarcity is not enforced, and title transfer is likewise not enforced. But substitute Napster with blockchain and substitute mp3 with token, and now the digital world’s problem of how to enforce scarcity and title transfer is solved.
In that hypothetical, if you use blockchain technology to tokenize all digital music files, each digital music file is a form of an NFT. This is because the digital music files are neither objectively nor subjectively fungible. This means NFTs are not intended to be mutually interchangeable units of account like U.S. dollars or bitcoin. Further, not everyone believes that an MP3 of Unchained Melody by The Righteous Brothers is mutually interchangeable with an MP3 of Unchained Melody by Paul Cauthen. Accordingly, NFTs can be thought of as tokens that represent ownership, title, and custody of unique assets, whether those assets are digitally native like MP3 files or analogue like canvas paintings. Additionally, NFTs can exhibit the characteristics of scarcity and exclusionary ownership rights in the same way as fungible tokens like bitcoin.
But what about the securities laws?
Much hand ringing has been done about whether fungible tokens like BTC, ETH, and XRP are securities. Certainly, we think fungible tokens could be securities. For example, companies could issue common stock of the same class as a fungible token. Further, under certain circumstances fungible tokens can be deemed to be securities by virtue of satisfying the investment contract test set forth in SEC v. W. J. Howey Co., 328 U.S. 293 (1946). See also Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985); William Hinman, Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018), https://www.sec.gov/news/speech/speech-hinman-061418.
Are NFTs securities?
Similar to fungible tokens, we think it is certainly possible for NFTs to be securities. But it is certainly possible for NFTs to avoid security status as well. Each NFT should be examined case by case to determine whether the economic substance of the NFT or the circumstances surrounding the offer and sale of an NFT satisfies the definition of security. This is what regulators typically mean when they say developers of digital assets should not elevate form over substance. It’s the Shakespeare rule of securities law, a security by any other name is still a security.
What has the SEC said recently about NFTs?
Recently, the SEC brought its first two cases against developers of NFTs.
On August 28, 2023, the SEC issued a settled administrative proceeding here against Impact Theory, LLC (“Impact Theory”). The SEC alleged that the NFTs sold by Impact Theory were investment contracts and therefore securities. The settled order found that Impact Theory violated the registration provisions of the Securities Act of 1933 (the “Securities Act”) by offering and selling NFTs without first registering those transactions or qualifying them for an exemption from registration.
Impact Theory was described as a media and entertainment company seeking to build brands and intellectual property in the same manner as The Walt Disney Company. Impact Theory offered and sold digital assets known as Founder’s Keys in the form of “purported” NFTs. According to the order, Impact Theory promoted their NFTs by saying, among other things, “NFTs are the mechanism by which communities will be able to capture economic value from the growth of the company that they support.” Founder’s Keys were intended to be bought and sold in the secondary market, i.e., traded on crypto exchanges.
Impact Theory agreed to several undertakings. One of the undertakings was as follows: “Revise the smart contract(s) or any other programming code(s) or computer protocol(s) underlying the [Founder’s Keys] to eliminate any royalty that Impact Theory might otherwise receive from any future secondary market transactions in [Founder’s Keys]….” (emphasis added). No fraud charges were alleged.
Then, on September 13, 2023, the SEC issued a settled administrative proceeding here against Stoner Cats 2, LLC (“Stoner Cats”). The SEC alleged that the NFTs sold by Stoner Cats were investment contracts and therefore securities. The settled order found that Stoner Cats violated the registration provisions of the Securities Act by offering and selling NFTs without first registering those transactions or qualifying them for an exemption from registration.
According to the order, “[t]he purpose of the Stoner Cats NFT offering was to fund the production of an animated web series called Stoner Cats. Each Stoner Cats NFT was associated with a unique still image of one of the characters in the Stoner Cats web series, with different expressions, apparel, accessories, and backgrounds, resulting in a multitude of NFTs. Purchasers could not choose their NFT in the offering, but instead received a random allocation. …While purchasers may ‘own’ their particular Stoner Cats NFT, Stoner Cats specifically reserved all commercial rights to the underlying intellectual property, including the images of the characters.” But “[t]he Stoner Cats NFTs [did] provide holders with exclusive access to view the [animated] Stoner Cats series,” although only one Stoner Cats NFT was required to watch the show. Additionally, the Stoner Cats NFTs were designed to pay Stoner Cats a 2.5% royalty fee each time a Stoner Cats NFT was traded in the secondary market. (emphasis added).
Stoner Cats agreed to several undertakings. But unlike Impact Theory, Stoner Cats was not asked to eliminate any royalty that Stoner Cats might receive from any future secondary market transactions in Stoner Cats NFTs. Similar to Impact Theory, no fraud charges were alleged.
What have people said about these cases?
With respect to Impact Theory, two SEC commissioners Hester M. Peirce and Mark T. Uyeda, dissented saying the following:
“We understand why the Commission was concerned about this NFT sale. Even though we believe strongly that adults should be able to spend their money as they choose, we share our colleagues’ worry about the type of hype that entices people to spend almost $30 million for NFTs seemingly without having a clear idea about how they will use, enjoy, or profit from them. This legitimate concern, however, is not a sufficient basis to pull the matter into our jurisdiction. The handful of company and purchaser statements cited by the order are not the kinds of promises that form an investment contract. We do not routinely bring enforcement actions against people that sell watches, paintings, or collectibles along with vague promises to build the brand and thus increase the resale value of those tangible items.”
Those same commissioners went on to say the following in Stoner Cats:
“The application of the Howey investment contract analysis in this matter lacks any meaningful limiting principle. …Were we to apply the securities laws to physical collectibles in the same way we apply them to NFTs, artists’ creativity would wither in the shadow of legal ambiguity. Rather than arbitrarily bringing enforcement actions against NFT projects, we ought to lay out some clear guidelines for artists and other creators who want to experiment with NFTs as a way to support their creative efforts and build their fan communities. …[Further,] NFT creators, along with other artists, do not get a free pass from the securities laws. In some instances, sales of NFTs may implicate our securities laws. In applying the securities laws in this space, however, the Commission must take care to preserve the ability of artists to sell their work, build a fan base, and involve that fan base in future creative endeavors.”
Implicit in these dissents seems to be the conclusion that the SEC has incorrectly adopted an “ends justify the means” ideology. Other commenters seem to tacitly agree with the SEC’s approach, rationalizing the outcome, “It’s not clear that these sorts of NFTs are securities, as a legal matter, but as a practical matter they kind of are.”
This is troubling because in a nation of laws, not men, process matters. Imagine recasting the foregoing sentiment in terms of the Fourth Amendment to the U.S. Constitution: “It’s not clear that this smoking gun obtained without a warrant can legally prove your guilt, but as a practical matter it kind of does.” A society intending to restrain tyranny cannot abide that sentiment flourishing.
Additionally, the dissenting commissioners sounded the alarm for existing NFT developers, some of whom may have vibrant brands with numerous satisfied customers. “Does this action indicate that the Commission generally views previous NFT offerings as securities offerings? If so, will the Commission provide specific guidance to those issuers describing what they need to do to come into compliance?”
One potential NFT developer that may be impacted by these settlements is Dapper Labs Inc., the developer of CryptoKitties. According to the CryptoKitties website found here, their digital assets, which appear to be a form of NFT, are described as follows:
“CryptoKitties are NOT a cryptocurrency. They’re a cryptocollectible. The real-world analogy for a cryptocurrency is dollars or pounds; a cryptocollectible’s real world analogy is closer to assets like baseball cards or fine art. As dictated by the smart contract, any CryptoKitty you own belongs to you. Like any product or property you can own, the market price is determined by supply and demand.”
The terms of use for CryptoKitties here says, “CryptoKitties is a distributed application that runs on the Ethereum network, using specially-developed smart contracts …to enable users to own, transfer, and breed genetically unique digital cats….”
To be clear, we express no opinion with respect to CryptoKitties other than to notice that they seem to be the type of NFT that the SEC would consider scrutinizing.
Where do NFT developers go from here?
Creators and entrepreneurs would benefit from a more predictable regulatory environment. To produce this environment, we believe looking to past precedents can inspire guiding principles for designing NFTs that are not securities. Accordingly, developers should focus on NFTs that would fall outside the definition of security provided that the NFTs can be structured to avoid being deemed an investment contract. These types of NFTs are likely to be those with characteristics similar to accounts receivable, royalty payments, and collectables such as art, comic books, and randomly allocated packs of baseball cards,
Notably, despite purportedly applying the Howey test, the SEC seems to focus on three characteristics of NTFs in these recent cases: (1) the proportionality of the price paid for the NFT as compared to the SEC’s own opinion on the benefits the NFT provides the purchaser; (2) the ease with which the NFT can be traded in the secondary market; and (3) the expectation of profits from the entrepreneurial and managerial efforts of the NFT developer.
Here, we will address accounts receivable and royalty payments. We’ll address collectables in a subsequent post.
Consider what we can learn from the no-action letter issued here to Royalty Pharma on August 13, 2010. The staff of the Division of Investment Management concluded that it would not recommend enforcement action to the SEC under Section 7 of the Investment Company Act of 1940 (“Investment Company Act”) against Royalty Pharma if Royalty Pharma continued to engage in the following operations, among other things, without registering with the SEC as an investment company:
- Engage primarily in the business of purchasing royalty interests obligating others to pay royalties to Royalty Pharma
- Purchase royalty interests that entitle Royalty Pharma to collect royalty receivables that are directly based on the sales price of specific biopharmaceutical products that use intellectual property covered by specific license agreements.
Typically, if a company has no other business operations other than to acquire or trade securities as a passive investor, that company would be an investment company subject to the rigorous regulations of the Investment Company Act. If the royalty rights held by Royalty Pharma were deemed to be securities, then Royalty Pharma was trending towards meeting the definition of investment company.
Obviously, one of the best ways to avoid being regulated as an investment company is to avoid the definition of investment company. Grossly over simplifying, under the Investment Company Act, an investment company is any company which “is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities.” § 3(a)(1) of the Investment Company Act (emphasis added). If the royalty interests and other licensing arrangements referencing the intellectual property of goods sold in commerce are securities, then Royalty Pharma would be an investment company unless an exclusion from the definition applied.
Unfortunately for NFT developers, the Royalty Pharma and the SEC staff avoided the security status question in footnote two of the no-action letter. Instead, Royalty Pharma got to avoid regulation under the Investment Company Act by relying on an exclusion from the definition of investment company used by factoring companies, which are finance businesses engaged in the business of acquiring accounts receivable. See § 3(c)(5)(A) of the Investment Company act.
But the value of the Royalty Pharma story does not end there. Approximately ten years later, Royalty Pharma went public. Its Form S-1 registration statement went effective here on June 15, 2020. According to the registration statement of Royalty Pharma accessed here, Royalty Pharma “intend[s] to conduct [its] business so as not to become regulated as an investment company under the …Investment Company Act. …[Additionally, Royalty Pharma is] engaged primarily …in the business of purchasing or otherwise acquiring certain obligations that represent part or all of the sales price of merchandise.” By going public using Form S-1, Royalty Pharma went all in on the conclusion that it was not an investment company.
Does this imply that the SEC believes the royalty assets held by Royalty Pharma are not securities? Potentially. Notwithstanding the fact that § 3(c)(5) does not have a public offering condition like §§ 3(c)(1) and (7) of the Investment Company Act, we are skeptical that the SEC would permit Royalty Pharma to offer securities to retail investors and fail to provide the protections afforded to investors under the Investment Company Act if the royalty assets were securities. Thus, if NFTs look like the assets held by Royalty Pharma, those NFTs may not be securities.
How do royalty assets like royalty receivables fare when stacked up against factors the SEC has been citing in recent NFT cases?
1. The proportionality of the price paid for the NFT as compared to the SEC’s own opinion on the benefits the NFT provides the purchaser.
“Royalty receivables are calculated as a percentage of product sales. Royalty Pharma’s practice in purchasing royalty interests is to complete a thorough assessment of the products that will generate the royalty receivables. In this regard, Royalty Pharma analyzes clinical data, consults leading clinicians using the product, evaluates the strength of the product marketers, and identifies current and pipeline competition. Royalty Pharma uses this assessment, as well as other relevant information, to evaluate the sales potential of the product and calculate the present value and future value of the product’s royalty stream.”
2. The ease with which the NFT can be traded in the secondary market.
The ability and frequency of trading royalty assets was not addressed by the no-action letter. Instead, the no-action letter indicates that Royalty Pharma is primarily engaged in the business of buying and holding royalty assets for purposes of receiving an income stream.
3. The expectation of profits from the entrepreneurial and managerial efforts of the NFT developer.
“Royalty Pharma owns royalty interests tied to sales of products that are marketed by leading pharmaceutical and biotechnology companies.” Accordingly, their appears to be a reasonable expectation of profit to be derived from entrepreneurial and managerial efforts to drive consumer demand for the products from which the royalty payments are derived.
The first factor suggests that if the price paid for the NFT is derived from a valuation methodology that is based on reasonably ascertainable estimates of sales, future value, and present value of payment streams tied to those sales, then an NFT conferring whole royalty rights to its holder may not be a security.
The second factor stands alone because it was not addressed in the no-action letter. Further, blockchain technology can easily facilitate active secondary markets for assets that were once very illiquid. The SEC seems to be emphasizing this characteristic as justification to expand the outer bounds of the Howey test. Without legislative or judicial input, this likely goes too far.
Based on how the SEC is weighing reliance on third-parties in these recent cases, the third factor weighs in favor of considering royalty assets securities. Yet, Royalty Pharma continues to be excused from the Investment Company Act by the SEC.
Given the regulatory status of Royalty Pharma, NFT developers and their securities counsel should consider looking to the Royalty Pharma no-action letter for inspiration when designing NFTs whose value is similarly derived from intellectual property.
Conclusion
The intent of this post is to inspire a more thoughtful approach to regulating NFTs. Is the Royalty Pharma no-action letter the answer? We don’t know. One flaw with the approach is that the SEC staff declined in the no-action letter to opine on the security status question. Even if it did, the SEC staff would have done so under the Investment Company Act , not the Securities Act or the Securities Exchange Act of 1934. Significantly, the definition of security under these statutes has not always been interpreted as being coextensive.
Nonetheless, there is more to be said. In part two of this post, we will wrestle with the question posed by Commissioner Hester Peirce: “Are there useful ways for the Commission to categorize NFTs for purposes of thinking about whether and how the securities laws apply to offers and sales?”
Post Date: October 18, 2023