On March 11th, Beeple became the third highest paid living artist with a $69M sale of one of his works as an NFT, a non-fungible token on the blockchain. This sale is one of many at the front of NFTs, blockchain’s latest hype machine of digital collectibles. Entire marketplaces have emerged to facilitate the sale of NFTs, but what if one of the most popular NFT marketplaces is breaking securities laws?
I have written many articles on Initial Coin Offerings (ICOs) back in the day, sometimes trolling the very concept of an ICO, because it was so obvious they were offering securities under the guise of being a simple token and taking money from unsuspecting investors. We all know how that story ended. $14B in investor dollars vanished into the ether(eum), a blockchain black hole, and many companies that raised funding through an ICO were later fined for the unregistered sale of securities.
The new superstar today is NFTs (non-fungible tokens). These are smart contracts on the Ethereum blockchain that first began as a modern twist of Tamagotchi in the form of CryptoKitties as well as collectibles (think digital baseball cards).
Today, the idea of what can be sold as an NFT is rapidly evolving. Living painters are selling their art as NFTs. Musicians are selling unique compositions as NFTs. Jack Dorsey, the founder & CEO of Twitter, sold his first tweet as an NFT for $2.9M (to Dorsey’s credit, the proceeds went to charity).
Millions of dollars are being spent and traded. Are those people who buy NFTs collectors or investors? Who is really selling these NFT and profiting from it?
Unpacking these questions of the NFT hype machine are important to answer in order to determine whether NFTs are securities. If they are, all of those NFT promoters and artists are committing a securities violation. That spells trouble with the Securities and Exchange Commission (SEC). The regulators, which include the SEC, the Treasury and all 50 State Administrators, would not be too happy to learn that people are receiving millions of dollars for the sale of unregistered securities.
But let’s start from the beginning. What is a security, and why is this important? Luckily for us, there is a Supreme Court precedent and a test to determine whether something is a security. This test is called the Howey Test, and how it works is simple. A transaction just needs to meet these requirements:
A person invests their money in a common enterprise.
The person is led to expect profits.
That expectation came solely from the efforts of the promoter or a third party
Pretty simple in theory. However, add what the regulators like to call “facts and circumstances” to this formula. Now the issue gets complicated and begs the interpretation of experts in the world of securities.
So let’s peel the onion and see where it takes us.
An NFT is not a common enterprise. It is actually a piece of code on a blockchain called a smart contract. However, it is sold by a common enterprise to investors.
Take for example Nifty Gateway, which sells artwork pieced into many NFTs, and each NFT represents the same piece of artwork. This artwork is also available to anyone to download and use. However, only those who own one of the NFTs sold can actually claim ownership of this artwork.
In other words, Nifty Gateway, a common enterprise, created the NFTs, decided on the number of NFTs to sell, and then offered them for sale on their website for a very limited period of time with a countdown timer to create buyer’s FOMO (Fear Of Missing Out). Feels like a high pressure penny stock offering to me.
The second question is whether buyers are led to expect profits. At least for now, it seems Nifty Gateway is packaging these NFTs as an investment that can appreciate, promising artists and collectors that there will be a value increase. How would the company know this?
They list the price someone paid, and then the price the next buyer paid to purchase it from the original buyer, always for more money. Nifty runs the secondary marketplace, thus creating liquidity and expectation of profits from the buyers.
To add complexity to this story, the artist actually gets a slice of every transaction, which also could be called a royalty. This royalty is permanent and paid via the smart contract. You could argue that the royalty does not make the NFT a security because no person is paying that royalty, the smart contract is.
However, the smart contract was created by a common enterprise, Nifty Gateway. The collector does not own the NFT outright; they own an interest in the digital artwork and do not really own it because they own a royalty in perpetuity. Therefore, it appears to be an investment contract, which supports the idea that the Nifty Gateway NFT is a security.
If it looks like a duck and quacks like a duck...
The final question is whether the expectation of profit comes solely from the promoter, which is in this case Nifty Gateway. Let’s recap.
Nifty Gateway finds an artist and signs them up to drop pieces of digital artwork on Nifty’s website. Nifty takes the artwork and creates NFTs of it, paying the artist a commission. Then, once the NFT is sold to a collector, Nifty handles the secondary market on its website to facilitate the NFT being traded between collectors, and shows the price climbing over time.
All the while, the artist gets royalties on every transaction from the beginning until the end of the universe. Or whenever the immutable blockchain becomes mutable.
To add to this, you are seeing celebrities promote NFTs, such as Elon Musk who offered his musical NFT artwork for auction to the highest bidder. But then, after getting a call from his lawyer, retracted the auction. Sound familiar to when the SEC fined boxer Floyd Mayweather and musician DJ Khaled for promoting ICOs?
What is the antidote? NFTs can be sold using a Reg A+ (no trading restriction) or Reg Crowdfunding offering (with 1 year trading restriction) and then traded on an Alternative Trading System (ATS) operated by a broker-dealer.
Despite the promise of blockchain’s capabilities, it shows signs of one of humanity’s oldest lessons: history repeats itself.