Fractionalized non-fungible tokens (NFTs) have become
increasingly popular within the ever-developing field of
cryptocurrency, particularly in the distribution of digital art.
NFTs use the same technology behind cryptocurrencies to create a
certificate of ownership for a specific digital file that cannot be
copied or forged. Each NFT is unique in value, granting the holder
exclusive rights to a piece of a larger artwork. While some view
NFTs as an avenue to be part of an exclusive group of digital art
purveyors, some see potential investment in speculative blockchain
technology, blurring the line between a “collectible” and
a “security.”
On March 11, 2021, an anonymous cryptocurrency entrepreneur paid
$69.3 million for a digital piece of art, the third-highest price
ever paid for a work by a living artist. In previous months, the
entrepreneur had purchased 20 digital artworks by the same artist,
each time dividing up the portfolio of NFTs into blockchain-based
tokens to sell fractionalized interests in the market. As the
auction around the most recent art piece intensified, more people
rushed to buy the tokens, increasing their value to $51 million by
March 11.1
While it is not currently against the law for someone to buy,
resell and promote the value of digital assets, Securities and
Exchange Commission (SEC) Commissioner Hester Peirce warned that
issuing fractionalized NFTs could be considered investment
contracts under U.S. securities law. At a recent conference, Peirce
said, “You have to be very careful if you decide to take a
bunch of NFTs, put them in a basket, break them up and then sell
fractional interest[s], or you decide to take one NFT and sell it
in parts.”2 Peirce emphasized that the
“definition of security can be pretty broad” and that
certain fundraising efforts related to NFTs may “raise the
same kinds of questions that ICOs [initial coin offerings] have
raised.”3 This is especially true because the value
of an NFT is based entirely on demand for the token rather than
fundamental economic principles that typically influence market
prices.4
SEC Staff published a framework analysis outlining
characteristics that are more likely to subject digital assets to
U.S. securities law under the traditional Howey test.5
For a financial instrument to be classified as an investment
contract, and therefore a security, the Howey test requires an
investment of money in a common enterprise with the expectation of
profits from the investment derived from the efforts of a promoter
or third party.6 While the framework provides many
examples of managerial or entrepreneurial efforts that could create
a reasonable expectation of profits, there is currently little
Commission-approved (or official) SEC guidance regarding digital
assets under the Howey test save for the DAO Report,7 No
Action Letters and enforcement actions. Ultimately, the conclusion
of whether a digital asset is a security depends on the economic
reality of the transaction and the manner in which the digital
asset is offered and sold, including marketing efforts.
While the rise in popularity of digital art has allowed some
artists to capitalize on the frenzy, prospective buyers should be
aware that they may be holding a security if, among other things,
any of the following apply:
- Digital art sales are marketed as a fundraising effort that
pools investor funds to build a platform or enterprise. - Promoters’, sponsors’ or any active participants’
marketing efforts are intended to increase the value of the digital
art tokens. - The digital art is created and sold as a way for the public to
earn investment returns.
Footnotes
1 Gerrit De Vynck and Douglas MacMillan, He just spent
$69 million on a digital piece of art. It’s not his first
Beeple. The Washington Post, Mar. 18, 2021, https://www.washingtonpost.com/technology/2021/03/17/nft-beeple-metakovan-christies/.
2 Elenora Spagnola, Hester Pierce (SEC): NFTs are not
investment products, The Cryptonomist, Mar. 26, 2021, https://en.cryptonomist.ch/2021/03/26/hester-pierce-sec-nfts-are-not-investment-products/.
3 Sophie Kiderlin, The SEC’s ‘Crypto Mom’
Hester Peirce says selling fractionalized NFTs could be illegal,
Markets Insider, Mar. 26, 2021, https://markets.businessinsider.com/currencies/news/sec-crypto-mom-hester-peirce-selling-nft-fragments-illegal-2021-3-1030250153.
4 Robyn Conti and John Schmidt, What You Need To Know
About Non-Fungible Tokens (NFTs), Forbes, May 14, 2021, https://www.forbes.com/advisor/investing/nft-non-fungible-token/.
5 SEC v. W.J. Howey Co., 328 U.S. 293 (1956).
6 SEC, Framework for “Investment Contract”
Analysis of Digital Assets, Apr. 3, 2019.
7 SEC, Report of Investigation Pursuant to Section 21(a)
of the Securities Exchange Act of 1934: The DAO, Jul. 25,
2017.
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guide to the subject matter. Specialist advice should be sought
about your specific circumstances.