Until fall 2023, there were few SEC enforcements or litigations involving securities issues with non-fungible tokens (“NFTs”). This has changed dramatically. In rapid succession last fall, the SEC undertook two enforcements against NFT projects for alleged securities law violations. Yet, the SEC has declined to provide regulatory guidance or rules regarding the treatment of NFTs as securities. Instead, the agency has chosen to engage in selective enforcement against NFT projects. This year, the SEC has ramped up its enforcement efforts against digital asset marketplaces for selling NFTs (and other digital assets) the agency alleges are securities. In each of these actions, the SEC has cited the use of smart contracts to trigger resale royalty payments to the NFT issuer upon the resale of an NFT as evidence supporting the classification of the NFT as a security.
In response, some potential targets for SEC enforcement have proactively sued the SEC, challenging its jurisdiction to regulate digital assets and/or seeking a declaration that the digital assets are not securities. Escalating tensions further, several private plaintiffs have also filed civil lawsuits against NFT issuers and/or marketplaces.
However, the crypto industry is buoyed by the prospect of a record number of pro-crypto legislators poised to take seats in the House and Senate under the incoming administration. The President-elect’s selection of notoriously pro-crypto individuals for leadership roles, such as Paul Atkins as SEC chair and David Sacks as “White House Crypto and A.I. Czar”, should stoke further optimism within the industry. Furthermore, a bill has been introduced in Congress which aims to bring clarity to NFT legal issues.
In the interim, anyone issuing NFTs or operating NFT marketplaces should take note of the recent flurry of NFT regulatory and litigation activity and assess whether they can mitigate the risk of being the next entity on the receiving end of an enforcement action or lawsuit.
Read on for more detail on these recent developments and some key takeaways.
Recent SEC NFT Enforcements
On August 28, 2023, the SEC instituted cease-and-desist proceedings against Impact Theory, LLC (“Impact Theory”), a Los Angeles media and entertainment company, alleging that the company’s sale of NFTs violated registration requirements under Section 8A of the Securities Act of 1933 (the “Act”). We covered that here.
Impact Theory sold $30 million worth of NFTs. Accompanying those sales, were numerous promises by the company that the NFTs would increase in value. The SEC charged that the NFTs therefore constituted investment contracts under the 1946 United States Supreme Court case Securities Exchange Commission v. W.J. Howey. The SEC reasoned that the NFTs constituted securities because of Impact Theory’s promises of price appreciation. It found that purchasers of the NFTs had a reasonable expectation they would receive a future profit resulting from Impact Theory’s managerial and entrepreneurial efforts to “build the next Disney.” The SEC also referenced the existence of resale royalties as a factor in its decision.
Days later, on September 13, 2023, the SEC charged Stoner Cats 2, LLC (“SC2”) with conducting an unregistered offering of crypto asset securities in the form of NFTs that raised approximately $8 million from investors to finance an animated web series called Stoner Cats. We covered this here. Again, the SEC referenced the existence of resale royalties as a factor in its decision.
On September 16, 2024, the SEC instituted cease-and-desist proceedings (the “Order”) under Section 8A of the Act against Flyfish Club, LLC (“Flyfish”) over restaurant-related NFTs the SEC alleges are securities. Proceeds from sales of the Flyfish NFTs were used to finance the construction and launch of a private members-only restaurant called Flyfish Club. The NFTs grant owners club membership. The SEC alleged Flyfish engaged in significant marketing efforts to promote the NFTs as investments, and led investors to expect profits from Flyfish’s efforts. According to the Order, Flyfish told investors that they could potentially profit if the club became successful, either by reselling their NFTs on the secondary market at appreciated prices, or by leasing their NFTs to others interested in accessing the club as a “passive income strategy.” Per the Order, 42% of investors bought more than one NFT in the offering, even though only one Flyfish NFT is required to gain membership. The Order further provided that Flyfish agreed to destroy all Flyfish NFTs in its possession and stop accepting royalty payments from secondary market sales of the NFTs, among other undertakings.
NFT Artists File Preemptive Lawsuit Against the SEC
Rewind to July 29, 2024, when two artists filed a preemptive lawsuit against the SEC challenging the agency’s authority to regulate NFTs. Musician Jonathan Mann and artist and law professor Brian L. Frye filed a civil complaint against the SEC, seeking a declaratory judgment affirming that NFTs representing ownership of their works do not constitute securities. The lawsuit is intended to proactively bar the SEC from engaging in enforcement actions against future sales of their NFT digital art.
The SEC Targets Digital Asset Marketplaces and the Marketplaces Fight Back
On August 28, 2024, OpenSea (the largest NFT marketplace) disclosed that it received a Wells Notice from the SEC for selling NFTs on its platform that are allegedly securities. The Wells Notice is not public, but presumably the allegation is that OpenSea’s business activities constitute the operation of an unregistered securities exchange. In a notable response, OpenSea has contributed to an NFT legal defense fund that has raised $6 million to help cover legal fees for NFT creators and developers to defend against similar Wells notices they receive.
After receiving a Wells Notice from the SEC, in October 2024, Crypto.com filed a lawsuit against the agency seeking a declaratory judgement to prevent the SEC from unlawfully expanding its jurisdiction to cover secondary-market sales of certain network tokens sold on Crypto.com’s platform.
Class Action Lawsuits Alleging NFTs are Securities
On September 19, 2024, two OpenSea users filed a class action lawsuit against OpenSea alleging that the company’s NFT listings were “deceptive and misled the Plaintiffs into purchasing worthless and unlawful unregistered securities.” The plaintiffs’ arguments parallel those made by the SEC in the previously discussed NFT enforcements; namely that, the NFTs sold on the OpenSea platform meet the Howey criteria of an investment contract, and therefore, OpenSea is engaging in the illegal sale of unregistered securities. The plaintiffs further assert that OpenSea unjustly enriched itself by collecting fees and accepting payments from transactions linked to sales of unregistered securities (NFTs). Plaintiffs’ complaint also points to the Wells notice issued to OpenSea and the SEC’s successful NFT enforcements against SC2 and Impact Theory, as validation of its claims. OpenSea vigorously denies these allegation.
Interestingly, plaintiffs’ counsel said: “We’re not just suing OpenSea in a class action like other lawsuits that will follow ours; we want to use this litigation to help create the framework of NFTs moving forward …and to try to work on constructive NFT regulation so that people that were injured not only have a path to damages, but we can make sure this doesn’t happen again.”
Another securities class action lawsuit was brought by users against Nifty Gateway, alleging that Nifty violated federal securities laws by selling NFTs on its platform. The court granted Nifty’s motion to compel arbitration and stay the action pending the outcome of arbitration.
At least one other NFT-related class action has settled.
The SEC’s Reliance on Resale Royalties in Finding NFTs to be Securities
The recent flurry of SEC enforcements against NFT projects and marketplaces signals the SEC is decisively ratcheting-up its scrutiny of the NFT space. While this has come as a surprise to many, we have cautioned about SEC enforcements against NFTs dating back at least to early 2022.
One of the many troubling aspects of the recent enforcements is that the SEC predicates some of its analysis on the collection of resale royalties as a factor in concluding NFTs are securities. Given the ubiquitous use of NFT resale royalties, this has caused concern in the NFT community.
In the SEC’s enforcements against Impact Theory, SC2, and Flyfish, it identified the issuers’ receipt of royalty payments from secondary market sales of the NFTs as one factor indicating that the NFTs constituted securities. In the SEC’s 2019 Framework for “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019), it provided some guidance (the “Guidance”) on the applicability of Howey to digital assets. The SEC noted that, the focus of the analysis should encompass the “circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales).” While the Guidance was broadly stated to address digital assets (presumably including NFTs), it came on the heels of the ICO boom. Perhaps as a result, most of the factors discussed in the Guidance seem geared towards assessing ICOs. The Guidance did not provide detail on how the differences NFT technology presents might affect the analysis. Nor did the Guidance analyze whether or when the seller’s receipt of royalty payments for secondary market sales of a digital asset is a relevant factor.
Yet, the SEC has increasingly scrutinized the collection of resale royalties by NFT issuers as a consideration in the Howey analysis. According to the SEC, resale royalties incentivize the NFT issuer to undertake efforts to increase the value of and market for the NFTs. Arguably, this plays into the “common enterprise” and/or “efforts of others” components of the Howey test.
What’s troubling to the industry is that, despite a number of formal requests for guidance on how securities laws apply to NFTs, the SEC has refused to provide any NFT-specific guidance or formal rulemaking. Rather, the agency has continued to regulate by enforcement. In doing so, it is relying on factors not included in its Guidance.
More specifically, in its Guidance, despite referencing the well known elements of the Howey test for an “investment contract” – the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others – the SEC largely ignores the “common enterprise” prong of this test. What little it says about common enterprise is largely dismissive of this element of the test. The SEC states that courts generally have analyzed a “common enterprise” as a distinct element of an investment contract. And, in evaluating digital assets, it has typically found a common enterprise to exist. This is not particularly helpful. It adds that it does not view a “common enterprise” as a distinct element of the term “investment contract.” This selective disregard for the well established legal test set forth by the Supreme Court is troubling, particularly with respect to NFTs, where each token may be unique. Given the non-fungible nature of NFTs, presuming a common enterprise exists may not be warranted. This is just one area where NFTs may differ from fungible tokens. In some cases, this difference may compel the legal conclusion that there is no common enterprise. Yet, the SEC has failed to address this and other distinct aspects of NFTs.
In the SEC enforcements mentioned above, two of the Commissioners overseeing the administrative proceeding expressed strong dissents.
The SEC’s enforcement action against Impact Theory led to a dissent by Commissioners Hester M. Peirce and Mark T. Uyeda. They dissented in part because they disagreed with the application of the Howey analysis, stating “[r]egardless of what one thinks of the Howey analysis, this matter raises larger questions with which the Commission should grapple before bringing additional NFT cases.”
The same two Commissioners dissented in the SEC’s enforcement action against SC2. They noted that, the “application of the Howey investment contract analysis in this matter lacks any meaningful limiting principle” and could stifle creativity among artists. The dissent further emphasized that NFTs, like physical collectibles, should not automatically be considered securities just because they involve money. The dissenting Commissioners compared the Stoner Cats NFTs to Star Wars collectibles from the 1970s, suggesting that both serve to build fan communities and should not be subject to securities regulations.
Predictably, the same two Commissioners dissented in the SEC’s enforcement in the Flyfish matter. They contended that “[L]eaving crypto to be addressed in an endless series of misguided and overreaching cases has been and continues to be a consequential mistake.” They further argued that securities laws are not needed in this circumstance, and their application is harmful both in the present case and with respect to setting precedent for future cases. Rather, the Flyfish NFTs were simply a different way to sell memberships.
To date, the pleas in these dissents and industry requests for more comprehensive guidance or formal rulemaking, have gone unanswered. Absent some change in leadership at the SEC, which is likely to come post-election, the NFT industry is likely to face continued selective enforcements and more class actions.
The NFT Act
Despite all of the above, the embattled NFT industry’s legal troubles may find a solution through legislation. In September, Congressman William Timmons introduced the New Frontiers in Technology Act (“NFT Act”), which aims to address the legal and regulatory treatment of NFTs. The NFT Act’s most notable provisions include:
- A definition for certain covered NFTs, which excludes securities;
- The creation of protections for “covered” NFTs, a term which encompasses NFTs primarily purposed as art and collectibles, among other exempted categories; and
- A call for the Comptroller General, who is notably not a financial regulator, to conduct a study on NFTs, which will presumably inform future NFT-related legislation and regulation.
Should the bill be passed, it would mark a watershed moment for the NFT industry, and flip the script on the SEC’s NFT enforcement agenda.
Outlook for NFTs Under the Incoming Administration
Looking forward to a Trump presidency, it remains uncertain how the president-elect’s seemingly pro-crypto stance will translate into concrete policy and regulation for the industry. However, initial indications suggest that the incoming administration intends to foster a more supportive regulatory environment for the NFT space and the crypto at large, focusing on promoting innovation and growth through regulatory clarity rather than the enforcement-driven approach the industry has experienced of late. We will continue to closely monitor NFT-related developments leading up to the impending change in executive branch leadership.
Key Takeaways
Given the ongoing litigation and lack of formal guidance specifically addressing NFTs, past and future NFT issuers and marketplaces face some uncertainty. Despite this uncertainty, the following are some things to consider.
- 1. NFTs as Securities – Many NFTs that merely represent a license to a digital asset have not raised red flags for regulators. However, it is possible that an NFT can be a security. For example, if NFTs are used to represent ownership of shares of stock in a company, they could be securities. There are other scenarios where, depending on the totality of the facts and circumstances, NFTs may be securities. For instance, some experts have suggested that NFTs may be securities when: i) they represent fractionalization of an asset; ii) they represent a right to receive revenue (e.g., buy a tokenized song and get a share of future revenue from the song); or iii) pre-sale of NFTs that have no current use (e.g., presale of gaming NFTs where the video game does not yet exist and funds from the sale are used to build the game). Other scenarios may also cause NFTs to be deemed securities. Each scenario is fact specific and must be analyzed separately.
- 2. Resale Royalties – The role, if any, of resale royalties in determining whether an NFT is a security is just one factor in a broader analysis. To our knowledge, the SEC has not taken the position that the existence of resale royalties necessarily means an NFT is a security. But, it has relied on this as one part of the analysis. Thus, it is important to consider this as part of the overall analysis when structuring an NFT offering.
- 3. Marketing Statements – In addition to representing ownership of a digital asset, some NFTs also represent a bundle of rights and/or entitlements. As evidenced by some of the cases above, the SEC believes it is important to assess what an NFT represents, in addition to any marketing statements made by the issuer. To the extent the issuer’s statements convey efforts promised to be undertaken by the issuer and that those efforts will increase the value of the NFT, the SEC will deem this relevant to the Howey analysis.
Conclusion
Companies that have concerns about whether NFTs they have issued or plan to issue implicate securities laws should seek advice from a knowledgeable attorney, based on the specific facts of their offering. In some cases, certain actions can be taken to minimize the risk of an enforcement.