Thinking is Hard… That’s Why Everything is Securities Fraud – Part 2

At Layer1, we have discussed our thoughts on NFTs on several occasions here, here, and here. We also promised you a two-part series on NFTs here. If it’s been a while since you read that post, pour a comforting beverage of choice and jump into that deep dive. In this post, we deliver on part 2.

Previously, we rapped up our post saying, “Nonetheless, there is more to be said. In part 2 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?’” Recall that Commissioner Peirce was addressing the application of the federal securities laws to transactions of art and other collectables on blockchains. Does selling art using a blockchain cause that sale to be a securities transaction? Does preselling art on blockchains cause those pre-sales to be securities transactions?

Around Layer1, we like to say that compliance with most financial regulations follows a pretty straight forward sequence, definition, exclusion, registration, exemption, obligations (“DEREO”). Applying DEREO to securities law, consider these questions:

• Does the thing I want to sell meet the definition of security?
• Is there a statutory carveout that excludes the thing I want to sell from the definition of security?
• If the things I want to sell is a security and there is no exclusion, do I need to register the transaction or even the security itself?
• Notwithstanding the registration obligation, is there a statutory or regulatory exemption from registration?
• Finally, if there are no exemptions, what are my initial and ongoing obligations with respect to my registered securities?

As we noted in part 1, Commissioner Peirce in particular, was grappling with the first step in our sequence, the definition of security. Over simplifying, she essentially looks at the definition of security in the statutes, notes collectibles are not listed, and lands on the SEC’s last gasp at calling certain types of collectibles securities, the catch-all investment contract test or Howey Test. Skeptically, she says:

“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.”

Here, we will steel-man Commissioner Peirce’s argument and present a table illustrating how to start crystalizing her thoughts. Importantly, the table is a mere starting point to respond to the call to action from Commissioner Peirce. “Yes” indicates that the factor weighs in favor of meeting the definition of security and “No” indicates that either the factor does not weigh in favor of a security status or should not be relevant to the SEC.

Post Date: March 29, 2024